* RBA says will buy A$5 bln in Australian govt bonds
* Will buy bonds with 2- to 8-year maturity
* 10-year bond yields fall to 1.265% from 1.647% on Thursday
* Banks announce sweeping package for small businesses (Adds global context, economist comment)
By Swati Pandey
SYDNEY, March 20 (Reuters) - Australia's central bank bought A$5 billion ($2.87 billion) in local government bonds on Friday, in the first round of its unlimited quantitative easing programme as it looks to cushion the economic shock from the coronavirus pandemic.
The Reserve Bank of Australia's (RBA) operation is aimed at reducing the funding costs for banks so that cheap credit is freely available across the economy that is on the verge of its first recession in nearly three decades.
The move brings the RBA into an uncharted monetary policy setting of controlling the yield curve that only Japan has so far attempted but with little success in stimulating its economy.
During the 2008/09 global financial crisis, a combination of fiscal and monetary policy helped Australia dodge the recession that had enveloped most of the developed world, allowing the RBA to spurn unorthodox monetary policies.
Analysts still expect Australia's A$2 trillion economy to shrink this year, despite RBA's latest measures, with ANZ Banking Group estimating unemployment will surge to 7.8% from 5.1% now.
"Unfortunately we don't think these measures will be enough to prevent a contraction in the economy in Q2... But they will limit the economic damage to some extent and provide a better starting point for when the pandemic passes," ANZ economists wrote in a note.
RBA's efforts prompted Australia's major banks to announce a sweeping relief package for small businesses, offering hefty cuts of more than 100 basis points to lending rates as well as deferring repayments for those hit by the virus. now has nearly 800 cases of COVID-19, prompting the government to shut its borders and ban large public gatherings.
"The RBA is fully aware of the liquidity issues and so with the Yield Curve Control they plan to buy an unlimited number of bonds," said Jonathan Sheridan, chief investment strategist at FIIG.
"And the government has got to fund this with a fiscal response. They'll have to do a lot more and they'll have to issue more bonds so that the RBA can buy the short-dated ones to keep the yield at 0.25%."
The government is expected to unveil a second fiscal stimulus package within days. RBA cut its cash rate to an all-time low of 0.25% on Thursday following an out-of-schedule meeting and said it would do "whatever is necessary" to keep yields on three-year government bonds low. RBA's stimulus comes as global central banks took unprecedented steps this week to backstop financial markets with trillions of dollars of liquidity, joining governments in trying to mitigate the impact of the coronavirus.
Yet, the coordinated policy steps have largely failed to stem a rout in financial markets, with many fearing a deep worldwide recession and more haemorrhaging of investments. MKTS/GLOB
Earlier, the RBA had proposed to buy up to A$5 billion in bonds maturing in July 2022, April 2023, November 2027 and May 2028.
In response, Australia's 10-year government bond yields AU10YT=RR slipped to 1.173% from near 1.3% after its announcement on Friday morning and as high as 1.647% on Thursday. Yields on three-year bonds AU3YT=RR eased further to 0.3%, not far from the RBA's newly set target of 0.25%.
Across the Tasman Sea, New Zealand's central bank offered three-to-six month loans to banks while providing additional liquidity in the FX swap market to ensure lenders have easy access to cheap credit. RBA and its New Zealand counterpart have also re-instated swap lines with the U.S. Federal Reserve to help reduce dollar funding stress in money markets. door remains open for more, including other measures if needed," said Su-Lin Ong, a Sydney-based managing director at RBC.