Reserve Bank of India (RBI) governor D. Subbarao Rao talked up bond prices on Friday, pushing their yields down. The yield on the 10-year benchmark security dropped to 6.19% at close, sharply down from its Thursday intra-day high of 6.53%. (I am talking about the 8.24%, 2008 benchmark paper. The new 10-year, 6.05%, 2019 paper, issued in February, had a lower yield.) Yields and prices of bonds move in opposite directions.
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At 6.19%, Friday’s closing yield on the 10-year paper is much lower than what it was in mid-July 2008—around 9.5%. But it’s much higher than in early January. In fact, in the first week of January, after the central bank cut both its policy rates—the repo rate, at which it infuses liquidity into the system, and the reverse repo rate, at which it drains liquidity, by one full percentage point each—the yield on the 10-year paper dropped to 4.86%, a historic low. Since then, it has risen substantially, ignoring the impact of the rate cuts. The repo rate is now 5.5% and the reverse repo rate 4%, but the long-term bond yield is veering around a level when both policy rates were much higher.
Indeed, the central bank’s policy signals have not been transmitted to the credit market. But the bond market too has failed to reflect RBI’s monetary easing. While banks are reluctant to cut loan rates as they are not able to bring down the interest rates on deposits, the fiscal policy is playing spoilsport in the bond market.
In other words, what RBI has done in the monetary field has been undone by the government. There is ample liquidity in the Indian financial system, but despite that bond yields have been on the rise because of increasing government borrowing. The government needs to borrow more than what it had planned during the year because of various fiscal sops offered and not all of them are measures to combat the economic slowdown.
In the beginning of the year, the government announced an annual gross market borrowing programme of Rs1.45 trillion. Now, this has gone up to Rs2.05 trillion—the highest the government has ever borrowed from the market. And, it can go up further by around Rs30,000 crore. How could this happen? A combination of increased government spending that had not been budgeted and shortfall in tax collection. For instance, the revision of wages of Union government employees, following the recommendation of the Sixth Pay Commission, will cost the government some Rs15,700 crore but this was not accounted for in the fiscal 2009 budget. Similarly, the waiver of farm loans and fertilizer and food subsidy would cost the government around Rs70,000 crore.
Then there is the additional cost of at least Rs18,000 crore on account of the National Rural Employment Guarantee Scheme that assures 100 days’ employment in every financial year to one adult member of rural households. Analysts are also anticipating at least Rs33,000 crore shortfall in tax revenue, the primary source of the government income. In the first nine months of the fiscal year, total tax collection has been Rs3.09 trillion, about 61% of the budget target.
So, the government needs to borrow more from the market than it had originally intended to do. RBI had auctioned two dated securities of eight years and 14 years on Friday, raising Rs7,000 crore, and another Rs8,000 crore worth of bond auction is due in the last week of February. Bond dealers expect more auctions in March to raise an additional Rs25,000-30,000 crore. If that happens, the market may be weighed down by a glut of paper, and the benchmark 10-year bond yield can cross 7%, defeating RBI’s easy money policy.
Subbarao has promised to manage the government’s borrowing programme in the least disruptive manner. His assurance has calmed the frayed nerves of bond dealers, but if RBI wants to transmit its policy to the market, the governor must walk the talk. Sitting on a huge interest rate risk, the market is moving closer to the tipping point.
What can RBI do to keep the yield low and at the same time enable the government to borrow more from the market? One way of minimizing the interest rate risk could be issuance of floating rate bonds, or floaters. Typically, the yield on a floater is benchmarked to short-term one-year treasury bills and is reset every year, providing a hedge against rising interest rates. RBI can also buy bonds from the market directly. Yet another option before RBI is to take the bonds on its books through the private placement route. In other words, the central bank needs to print money to create liquidity. Technically, this is called monetizing the government’s fiscal deficit.
RBI should not feel shy of printing money since the inflation rate is heading down. This is a better way of creating liquidity than cutting the cash reserve ratio (CRR), or the portion of deposits that commercial banks need to keep with the central bank. Between October and now, RBI has cut banks’ CRR by four percentage points, from 9% to 5% and released Rs1.6 trillion into the system. Even if it goes for another CRR cut, it will not have an impact on bond yields if the government continues to borrow from the market.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai bureau chief of Mint. Please email comments to firstname.lastname@example.org.