Why RBI governor is playing Mr Bond8 min read . Updated: 02 Nov 2020, 06:03 PM IST
The central bank’s efforts to suppress bond rates via yield curve adventures is endangering its own inflation target
On 28 August, India’s central government failed to raise money from the bond market by issuing its most traded and liquid 10-year bond. The reason was that its banker, the Reserve Bank of India (RBI), rejected all the bids it received at the auction citing that the cost of borrowing for the government was high.
Bond investors were not pleased because they believed that amid rising inflation and economic uncertainty, the government should pay higher. Also, since the government intends to borrow an unprecedented ₹12 trillion from the market in FY21, the least it could do is compensate investors for the increased supply they will be swallowing. But since that auction, RBI rejected bids three more times for the 10-year bond. This stand-off highlights the fact that at times, the relationship between the bond market and RBI tends to turn combative.
There are a set of underlying broader economic questions behind these moves: Should we bother about the relationship between RBI and the bond market? Importantly, is RBI erring in its interference in the bond market and what is at stake here?
Before even attempting to answer those questions though, we need to know why RBI has been at loggerheads with the bond market. The reasons are aplenty but all of them lead to one thing: Pricing.
The price tag
The devolvement at four consecutive auctions led bond traders to conclude that RBI does not want the 10-year bond yield (or interest rate) to cross 6%. In August, when the 10-year bond was devolved for the first time, the yield in the secondary market was 6.15%.
The yield has since then dropped sharply to 5.88% in the secondary market. Besides outright yield signals through rejection of bids, RBI also used soft power. RBI governor Shaktikanta Das gave a veiled warning in early October that the market has to meet RBI halfway. “We look forward to cooperative solutions for the borrowing programme for the second half of the year. It is said that it takes at least two views to make a market, but these views can be competitive without being combative," Das had said.
Das is justified in expecting the market to give funds at a cheaper rate to the government. Amid a raging pandemic, governments worldwide are increasing their borrowing to spend and boost the economy. Being among the worst-hit economies should also give the Indian government enough reason to borrow more to spend. Ergo, markets should not punish the government with a higher cost of borrowing.
Further, the bond market has got nothing to complain about since RBI has ensured that investors are not starved of funds. The liquidity surplus is in excess of ₹5 trillion and the central bank has promised it would infuse more should the markets need it. Since January this year, RBI has infused more than ₹2 trillion into markets through targeted long-term repos (TLTRO), bond purchases, a special window for mutual funds to borrow and even through interventions in the forex market. Unlike in the past, RBI’s liquidity measures are not short-term but rather across the yield curve. Bond purchases and dollar sales in the forex market are considered long-term durable liquidity measures. To be sure, the bond market has taken note of these measures.
“There is ample demand at the shorter end of the curve because of liquidity and the RBI has been able to reduce long-end duration risk from the market by buying long bonds," said Hardik Dalal, director, head of loans and bonds at Barclays Bank. Sovereign bond yields are near decade lows helped by RBI’s measures.
In its pricing tussle, the central bank seems to be winning. But even for this, RBI had to become a big player in the bond market and intervene across the entire yield curve. This brings us to the troublesome part of RBI being a dominant player and why bond yields matter.
Why should we care
Bond yields have wide implications for the economy. The sovereign bond yield curve is the reference point for pricing most financial instruments in the economy.
Corporate bond yields are priced by adding a risk spread over the corresponding sovereign bond yield. Businesses compare their rate of return on their capital by using the sovereign yield as a reference point. In essence, the cost of long-term private sector capital relies heavily on the long-term low-risk sovereign bond yield.
Only when the private sector is able to borrow cheaply, it can set up factories, build roads and create jobs easily. When the government gets its funds cheaper, so do companies. Governor Das has said, “the orderly evolution of the yield curve is a public good."
The arguments for RBI to intervene in the market to keep government borrowing costs lower is stronger than ever since FY21 is expected to be a recession year. India’s private sector needs all the motivation it can get to invest. Low cost of borrowing is one such motivation. But interventions in the market by the central bank are neither simple nor are the outcomes binary. There are always trade-offs and downsides.
There are two usurious outcomes of widespread central bank interventions in the bond market. First, low bond yields may benefit borrowers but they hurt savers at the same time. Interest on various small savings schemes is derived by adding a mark-up to the corresponding government bond yield (see Chart 1). The interest rate on public provident funds and other retirement funds too are derived by using the prevailing sovereign yield as a point of reference. The Indian economy has a larger portion of savers than other emerging markets.
Ananth Narayan, associate professor of finance at SPJIMR, calls the current suppressed bond yields a form of financial repression. “I do not subscribe to the idea that we need to bring long-term yields down in the current juncture. At this point, this just leads to financial repression," he said. In fact, a member of RBI’s monetary policy committee pointed out that if the current negative real interest rates fall more, it would hit savings badly. For real interest rates to be positive again, inflation has to ease.
The inflation conundrum
Inflation is central to bond markets and to RBI’s monetary policy. Currently, long-term bond yields are suppressed artificially because of RBI’s operation twist and its rejection of auction bids. In other words, yields do not reflect the true picture of inflation.
“Left to the markets, bonds would have priced in the inflation risks," said Arvind Chari, head of fixed income at Quantum Advisors Ltd. Chari adds that the biggest worry for the bond market is inflation. Inflation has been above RBI’s mandated target of 2-6% for six continuous months now (see Chart 2).
The central bank expects it to ease to 4% by March but this hinges on a big drop in vegetable price inflation. Moreover, inflation expectations have been on the rise. The latest household survey done by RBI showed that Indians expect inflation to be elevated over the next one year.
Market participants fear that if inflation fails to follow RBI’s glide path, the central bank would be forced to prune down its policy accommodation. That means a slow tightening of monetary policy. Given that bond yields are suppressed, the climb would be steeper once the central bank decides to tone down its accommodative stance.
“An inflation targeting central bank prices the inflation risk for the bond markets by adjusting the policy interest rate to meet the inflation target," said Quantum Advisors’ Chari. “Today, with growth prioritized over inflation, policy rates and market yields are out of sync with inflation. So, this commitment to take off the inflation risk is endangered if inflation does not ease as expected."
An important factor that influences inflation is the government’s fiscal deficit. For a country like India, fiscal policy influences inflation a great deal because government expenditure is largely towards consumption rather than capital. When the government spends to encourage Indians to spend more, the demand boost results in price pressures.
As such, the government’s fiscal deficit is expected to balloon this year. While the odds of the government’s deficit feeding into inflation is low in FY21, it would only increase over time.
Market participants warn that governments have a poor track record of bringing down fiscal deficit swiftly. Suyash Choudhary, head of fixed income at IDFC AMC, warns that an elevated fiscal deficit is a multi-year problem. “It may be at least 3-4 years before the government reaches the deficit level of FY19… unless the government begins to aggressively start asset sales," said Choudhary.
One of the key signs of trouble ahead on inflation is the public debt as a percentage of gross domestic product (GDP). At the end of FY21, India’s public debt (central and state debt) is expected to reach 90% of GDP.
The need for financing and servicing this debt load would raise the minimum required borrowing by the government. “We are setting ourselves up for inflation. With the kind of debt level, somewhere we may have to inflate it away," says Narayan. What this means is if inflation rises, it erodes the value of money. Thus, it also erodes the value of debt.
But not everyone believes that RBI’s inflation target is at risk. To be sure, RBI has so far resisted monetizing the fiscal deficit directly. In other words, taking on bonds directly from the government. Indirect monetization through bond purchases from the market have been low compared with what the bond market wanted.
“RBI recognizes that the fiscal deficit is a multi-year problem which is why they may not be buying bonds in a big way," said Choudhary. So far in FY21, the central bank has bought just ₹30,000 crore worth of bonds. But experts believe the central bank will eventually enter the ring in a big way. It will have to increase its bond purchases. Every time RBI buys bonds, it suppresses the yield (or interest rate) in the market. A distorted sovereign bond yield results in a distorted private sector interest rate regime. Low interest rates in the past have resulted in elevated inflation especially when targeted towards consumption.
True, the odds of this are further down the lane. But today’s policy decides tomorrow’s inflation. In promising to keep rates low for long, RBI is avoiding the fact that there are long-term consequences to its actions and, hence, risking its inflation target in the medium-term.