The turbulence in the bond market
The Indian bond market has traditionally been condemned to live in the shadow of the equities market. It has had two unexpected moments in the sun in recent weeks.
The government announced on 27 December that it would need to borrow an extra Rs50,000 crore to fund the fiscal deficit. Benchmark bond yields jumped by 18 basis points the next day. The yield curve—or the gap between call money rates and the yield on 10-year bonds—was already at its steepest in the past seven years. The steep yield curve is a reflection of concerns about the inflationary consequences of a higher fiscal deficit, at a time when global oil prices are also climbing.
Matters went into reverse gear last week. The government on 17 January said it would need to borrow only an extra Rs20,000 crore—an announcement that was accompanied by speculation in trading rooms that the Reserve Bank of India (RBI) had decided to pay an interim dividend to the sovereign. Bond yields eased at once. They came down by 16 basis points.
It is not clear from this episode whether the bond vigilantes had actually sent the government back to the drawing board, or whether the lower extra borrowing was because of some other reason, but there is no doubt that the spike in bond yields did send a strong signal that higher fiscal deficits will have consequences in an economy with a narrowing output gap.
That was not all. Bond yields have climbed by nearly one percentage point over the past four months. The drop in bond prices—which move in the opposite direction of yields—will put pressure on banks that hold large bond portfolios, partly because of regulatory requirements and partly because of inadequate commercial lending opportunities. RBI deputy governor Viral Acharya told a meeting of the Fixed Income Money Markets and Derivatives Association that banks need to manage risks better when interest rates are rising, and that the regulator cannot be expected to bail them out each time their bond portfolios take a hit.
“Recourse to such asymmetric options—heads I win, tails the regulator dispenses—is akin to the use of steroids. They get addictive,” Acharya told his audience last week. He specifically mentioned three episodes of rising interest rates—in the second half of 2004, after the worst shocks from the global financial crisis, and during the taper tantrum. The Indian central bank had to step in to ease the pain. It is also important to remember that Acharya had stated in the June 2017 meeting of the monetary policy committee that a central bank with an inflation mandate cannot use the interest rate instrument to target bank profits.
Bond yields climbed once again. The idea that regulatory forbearance should be used only in special circumstances is a sound one. The warning that banks will have to learn to manage their interest rate risks better comes at the same time when lenders have also been pushed by the central bank to deal with the consequences of their lending mistakes, rather than being allowed to sweep the problems under the carpet.
However, there are a few related issues. First, the large bond portfolios of Indian banks are clearly a result of financial repression, and thus there is a direct link between sovereign debt issuance and interest rate risks for banks. Second, there is a conflict of interest when the RBI tries to lengthen the maturity profile of sovereign debt in its role of banker to the government while at the same time wearing its regulatory hat to warn banks of the interest rate risks from holding government securities of a longer maturity. Third, active hedging of interest rate risks needs deep government securities markets as well as liquid derivative markets, and not just proactive bank treasuries.
The two recent episodes are important to the extent they are advance signals that the Indian bond market is coming into its own. It is also useful to remember in this context that it was selling by bond investors rather than equity investors that drove the rupee down during the taper tantrum of 2013. The Indian financial system is dominated by banks rather than bonds, but the latter are becoming more important. The question of how to deepen the bond market in an economy with fiscal dominance plus financial repression remains one of the central challenges for regulators.
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