A steep yield curve is symptomatic of fiscal profligacy and India’s bond market has punished the government in the past for straying on the fisc. But this year things have turned idiosyncratic in the bond market.
The benchmark 10-year government bond yield has dropped to 6.5%, nearly 100 basis points lower than a year ago.
The government’s fiscal deficit for FY20 is expected to widen to 3.8% against the budgeted 3.3% of gross domestic product (GDP). In FY19, fiscal deficit was 3.4% of GDP. In short, the government’s borrowing cost has dropped even as its finances are deteriorating.
All the credit goes to the government’s banker, the Reserve Bank of India (RBI).
RBI has now rolled up its sleeves and began to manage market yields by buying long-term bonds and selling short-term paper. Known as India’s version of the US Federal Reserve’s Operation Twist, RBI has effectively cut off bond yields from reality.
To be sure, India’s bond market is far easier to manipulate because it is bereft of depth. On any given day, only a handful of bonds get traded and volume is low.
This has made the central bank’s job of managing yields easier. Further, banks are captive investors and absorb a large part of the central government’s borrowing.
In all respects, India’s sovereign yields hardly reflect the true picture of the government’s finances. Even in the past, when bond yields have threatened to spiral, the central bank has stepped in to contain them.
Private companies can never command this luxury and are often punished severely. The corporate bond market is rife with examples that show bond investors giving the cold shoulder to anyone with a troubled balance sheet.
That brings us to the objective behind the Reserve Bank’s Operation Twist. For investment to perk up, long-term borrowing costs have to come down and for that, sovereign yields need to soften more.
To be sure, unlike the purchases of bonds by RBI in the past which effectively funded the government’s borrowing, this time the net position is neutral since bonds are being bought and sold. Also, the intention behind this strategy is noble.
However, transmission of a drop in government bond yields is not democratic and swift onto private credit. That is, corporate bond yields do not fall by the same margin and for all issuers.
For RBI’s efforts to bring down long-term borrowing costs, playing with sovereign bond yields is not enough.
The banking system is awash with liquidity but corporate bond yields haven’t had the benefit of this. The lines of transmission are frayed and RBI needs to address that. Meanwhile, Operation Twist is just another distortion.
