Are India’s Bond Markets Out Of Sync With Monetary Policy?

India’s 10-year bond yield is at elevated levels and should now correct, writes Soumya Kanti Ghosh.
A trader reacts as he monitors financial information on computer screens on a trading floor. (Photographer: Chris Ratcliffe/Bloomberg)
A trader reacts as he monitors financial information on computer screens on a trading floor. (Photographer: Chris Ratcliffe/Bloomberg)

The monetary policy announcement to maintain the status quo was largely on expected lines. However what was important was the Reserve Bank of India governor’s reassurance to the market in terms of continuing to support growth. Coupled with this, the RBI projection of inflation trajectory — that is supposed to see a slowdown in second half of 2018-19 — must have had a soothing impact on the bond market that rallied today.

Interestingly, the RBI also released the results of forward-looking surveys on Wednesday. As per the Inflation Expectations Survey, the proportion of respondents expecting prices to increase in the next three months at more than the current rate declined in the December 2017 round, across all product groups. Also, expectations of the rate of price rise over the next one year also moderated in a broad-based manner, as compared with the preceding round. The Order Books, Inventories and Capacity Utilisation Survey (OBICUS) in the manufacturing sector for July-September 2017 shows a slight uptick in capacity utilisation and substantial growth in new orders.

Clearly, the bond market should now correct itself from idiosyncrasies and the regulator may also play a role. 

The India 10-year government bond yield had been steadily declining from 2014 and was somewhat flat during the first half of 2017. But since the second half of 2017, yields have moved up by 114 basis points, in a period of about seven months. During the same period, the bond yield has also increased in five developed and developing countries (China, Germany, United Kingdom, United States and Euro Area) and it is within a range of 22-42 basis points.

We believe that currently, the 10-year yield in India is at elevated levels and not in sync with macro fundamentals.

The reason why we call these levels exceptionally high is that the spread between the overnight repo rate and the 10-year yield has increased to 169 basis points in February 2018 and the spread between overnight repo rate and state development loans’ yield has increased to 220 basis points. Such a large spread has been seen only a few times in the last decade and only during a crisis.

The previous two instances when this spread moved above 100 basis points came during the 2013 taper tantrum and in 2009 in the aftermath of the global financial crisis.

This spread has consistently increased over the last few months, ignoring even a sovereign rating upgrade which came after more than a decade of waiting.

The sad thing is that in countries that are doing worse than India in terms of macro fundamentals and stability — like Russia and South Africa — the bond yields have even declined on average. The increase in Indian bond yields is three times higher than the maximum increase for any country since it started rising from July.

Needless to say, such high yields push up government borrowing costs and are surely inimical to monetary policy transmissions, as this will put upward pressure on banks’ marginal cost of funds based lending rates.

What could be done to rein in high bond yields? First, RBI has to take a conscious call asymmetric liquidity management. Such liquidity management may have impacted the level, slope, and curvature of the yield curve.

  • In case of surplus system liquidity, RBI conducted sales via open market operations worth Rs 90,000 crore for permanent liquidity absorption.
  • When it came to liquidity deficit owing to government cash holding to meet its fiscal target, RBI was reluctant to conduct OMO purchases to inject permanent liquidity.

The policy has also taken several policy measures that will be helpful to micro, small and medium enterprises. RBI has allowed banks and non-bank lenders 180 days time to not downgrade the asset classification for non-repayment of dues by GST-registered MSMEs. This will definitely help cash-strapped MSMEs and banks, even as most of the MSME loan accounts are being mapped with their GSTN number.

Further, RBI has removed the credit caps on MSME (Services) under priority sector. This is a welcome step and will help banks meet priority sector lending targets, especially for public sector banks which are have shown a shortfall for the few years (since FY12). the applicability of sub-targets of small and marginal farmers and micro-enterprises for foreign banks with 20 branches and above will create a level playing field in the priority sector lending sphere.

Finally, a word on the global market rout. When a single trading session wipes out the entire yearly gains, it not an ordinary event but a black swan event that needs a very close look. The selloff in equities appears to have been in the making for some time. The factors that have contributed to this include a self-contradictory strategy of easy fiscal policy and tightening monetary policy in the United States.

Soumya Kanti Ghosh is Group Chief Economic Advisor at State Bank of India. Views are personal.

The views expressed here are those of the author’s and do not necessarily represent the views of BloombergQuint or its editorial team.

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