Focus on the term structure of rates2 min read . Updated: 17 Apr 2012, 10:07 PM IST
Focus on the term structure of rates
Ten-year government bond yields hit a high of 14% in 1996 and dropped to 5% in 2005. Currently at 8.4%, they are at an inflection point. Despite the 50 basis points (bps) rate cut, I see structurally high long-term rates. A couple of reasons drive this view.
Second, this year the government intends a net borrowing of Rs. 4.8 trillion. Net borrowing financing the fiscal deficit has increased in recent years, and is at 93% of the fiscal deficit. Besides the market, such a large borrowing can only be met by the Reserve Bank of India’s (RBI’s) open market operations (OMOs).
The banking system has been witnessing lower deposit growth due to low real yields and financial repression manifested in the form of gold imports. An increase in such imports represents capital outflows—as domestic assets get redenominated from rupees to gold. The aspect of low real yields can by gauged by the fact that despite raising policy rates by 525 bps since January 2010, inflation expectations are yet to meaningfully subside. In the inflation expectation survey for April-June, three-month and one-year inflation expectations were elevated at 11.7% and 12.5%, respectively—a sign of robust demand and incomplete inflation pass-through.
An important factor dominating the system is the increase in structural liquidity deficit—banks borrow larger sums persistently from RBI in the daily liquidity adjustment facility (LAF). A few factors have affected structural liquidity—adverse BoP and increases of currency with the public.
Adverse BoP challenges reserve money or primary liquidity. Reserve money in turn drives M3 (money supply) and deposit growth. There are two sources of reserve money—OMO purchases (monetization) and unsterilized foreign exchange intervention by RBI. Beyond a point, reserve money creation due to monetization is akin to bad cholesterol and has the effect of weakening the rupee.
What are the options for the central bank to help liquidity?
• RBI should let go its fear of the 1992 securities scam and permit double ready forwards that will help create a term money market.
• Longer-term repos such as the European Central Bank’s long-term refinancing operations should be introduced to impart permanency to borrowed reserves from LAF.
• Government auctions its surplus balances with RBI to banks.
• Statutory liquidity ratio (SLR) should be dispensed with temporarily during advance tax payments.
• If structural liquidity deteriorates and banks’ excess SLR comes down, widen the acceptance of collateral in LAF to include oil bonds and foreign currency deposits.
To sum up, RBI’s guidance is on limited space for further policy actions. Further, given the headwinds confronting the bond and money markets, the yield curve should steepen. Bond vigilantes need to ask whether there is value investing in long-tenor government bonds at near-zero real rates, given the inflation expectations and incomplete pass-throughs. A correction here will have implications for equity valuations, leverage and particularly the real estate sector.
Srinivas Varadarajan is principal—India, Mount Nathan Advisors.
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