The sharp rise in government bonds yields to beyond 8% has shaken not just bond investors but also all types of borrowers in the market. The episode of rising bond yields is not new, as in the past sovereign yields have risen in response to hardening inflation and even external shocks such as the one during 2013.
So why should we worry more this time around?
What is different this time is that the transmission of sovereign yields to the real sector through interest rates would be much faster and swifter than before.
The sovereign yield curve is the basis on which other assets are priced in the economy. But in the past, the rise in yields weren’t transmitted swiftly into the loan market just as the Reserve Bank of India’s (RBI’s) policy rate changes weren’t reflected.
That was because banks, the dominant lenders to the real sector, depended on public savings deposits and not on market borrowings. Since interest rates on deposits— especially savings—hardly changed, banks were able to cushion the impact of market rates onto loan pricing. This was also possible because of the way loan rates were calculated. RBI chose to improve transmission by introducing a new way to calculate lending rates.
This new way has improved the pricing dynamics of loans and made transmission faster.
But more importantly, the share of banks in funding the real sector has fallen compared with fiscal year 2014 (FY14). Banks funded 54% of the requirements of companies in FY14, which was down to 36% in FY18. Even during April-June of the current fiscal year, banks had lent only 4% of the incremental fund flow towards companies. Domestic non-bank sources accounted for more than 65% of the incremental borrowings of companies.
Markets are more efficient in transmitting risks to pricing than banks are, and therefore, companies are just staring at higher costs sooner than later. This comes at an unpleasant time when firms are finally trying to deleverage and reduce their interest payment load.
“Banks depend on current and savings deposits more than other types of sources of funds and so, the transmission had mostly been sluggish. But this time, the transmission of rising yields will be faster owing to multi-fold expansion in incremental market share by NBFCs and others, which may prove to be costly," said Soumyajit Niyogi, associate director at India Ratings and Research Ltd. NBFCs stand for non-banking financial companies.
Therefore, the reasons for the rise in bond yields may emerge from the same set of metrics both domestic and global. But the implications to the economy could be magnified now.