The liquidity-fuelled exuberance in India’s bond markets musn’t be allowed to continue.
The downward shift in the Indian yield curve in the past few weeks is clearly linked to the interbank call-money market, where rates slid to 0.63% last week.
That isn’t much costlier than in Japan and a clear hint that the Indian central bank will have to mop up excess liquidity if it wants to keep its much-needed hawkish monetary policy stance from turning ineffective.
The call rate should ideally move in the interest rate corridor set by the Reserve Bank of India’s benchmark short-term rates. The central bank currently withdraws liquidity from the banking system at 6% and adds it at 7.75%. Those should be the lower and upper bounds for call money. A rate of 0.63% is as incongruous as the high of 62% seen in March.
The macroeconomic conditions don’t warrant cheap money. Gross domestic product grew at a scorching 9.1% pace in the three months ended 31 March, government figures showed last week. More importantly, at 6.2 %, the GDP deflator had its largest jump from a year earlier since June 2000, showing it might be dangerous to dismiss concerns about overheating. “The policy preference for the period ahead is strongly in favour of reinforcing the emphasis on price stability and anchoring inflation expectations,” the central bank reiterated.
Votaries of growth
Benchmark wholesale-price inflation appears to be well contained at 5%, the lowest in more than eight months. That might make another increase in interest rates politically unpalatable.
Finance minister P. Chidambaram doesn’t want the economy to cool. He’s aiming for a second year of 9% GDP expansion. “The time has come to shed lingering doubts about the sustainability of high growth,” he says.
Business on his side
The Confederation of Indian Industry, the biggest lobbying group of business interests in the country, noted that last quarter’s 9.1% growth was lower than 10% a year earlier.
“We hope this is not indicative of any slowdown resulting out of actions taken to curb inflation during this period,” the confederation said in a press release.
Focus on liquidity
The rate at which the central bank adds overnight liquidity has risen by 175 basis points in the past 20 months. Some analysts say this is sufficient.
“Ultimately, the conduct of monetary policy also has to take account of the needs of growth and employment and stop focusing on a single-point agenda—inflation,” brokerage First Global Securities Ltd said in a May 30 research note.
Even if more interest rate increases are ruled out, the case for keeping a tight rein on liquidity still exists.
A temporary oversupply of domestic liquidity may have a beneficial side effect if it manages to break the Indian rupee’s relentless rise against the US dollar, a trend that’s making the currency a one-way bet for carry traders.
In March, Indian companies borrowed a record $5 billion overseas. It might become dangerous if borrowers persist in loading up on dollar loans betting that the rupee will keep rising and their debt-servicing costs will continue falling.
Awash with cash
The Indian rupee, the world’s fourth-best performer in the past three months, has risen 9% against the US dollar While a stronger currency has helped stabilize inflation, exporters have begun whining about a loss of competitiveness.
Yet, it will be disastrous to leave excess cash sloshing about in the banking system for long. Money supply is growing at an annual 20% pace. That’s four percentage points higher than the average in the last 10 years.
The yield on 10-year government bonds fell to its lowest in one-and-a-half months. It was the third straight weekly gain in bond prices.
Before the debt markets become too sanguine, the central bank will have to drain liquidity. Sure enough, late last week, the Reserve Bank increased the size of a treasury bill sale scheduled for 6 June. If that doesn’t do the trick, it may ask banks to set aside more money as cash reserves. That’s something the Indian central bank has already done three times in the past six months.
Waiting for liquidity to vanish on its own through higher government borrowing and corporate-tax payments may prolong the exuberance in the bond market; that will put the central bank’s inflation-fighting credentials at risk.
Regaining that credibility may then require another increase in interest rates, which will be costly for the economy.