Capping Bond Yields: RBI Is Fighting The Wrong Fight

What was it this time? Traders are citing a jump in wholesale inflation alongside the results of the first G-SAP auction, where the Reserve Bank of India bought limited quantities of the benchmark bond. The G-SAP, in case you missed it, is a newly minted bond purchase programme, under which the central bank plans to buy Rs 1 lakh crore in debt this quarter.

Yield rise, yields fall. The reason we’re paying a bit more attention to the recent swings is because the central bank is throwing a lot of ammunition at keeping bond yields in check. Many would argue that bond yields are rising for perfectly legitimate reasons and the central bank should let the market settle at a reasonable level by itself. The RBI doesn’t think so. It has used both words and actions in trying to bring that market into its corner.

It’s (Not) Only Words....

Most of the central bank’s attention has been focused on the keeping the 10-year bond yield down—some believe at close to 6%. It has gone much further than it has in the past.

In October, Governor Shaktikanta Das said “the orderly evolution of the yield curve” is a public good. “It’s said that it takes at least two views to make a market, but these views can be competitive without being combative,” Das said in an attempt to calm markets which were fretting about government borrowings in the second half. He repeated that message in December.

In February, when the RBI announced a two-phase reversal of a 100-basis-point emergency cut in cash reserve ratio announced last year, Das went to great lengths to assure the market that liquidity will remain abundant. “The CRR normalisation opens up space for a variety of market operations to inject additional liquidity,” said Das, almost assuring open market bond purchases.

In monthly bulletins, the central bank turned poetic.

In its March bulletin, the RBI said “bond vigilantes” could undermine the recovery, unsettle financial markets and trigger capital outflows from emerging markets. “...but it takes two to tango and forestall a ‘tandav’,” it said.

When words didn’t seem to do the trick, the RBI did step up actions.

At first it stuck to the standard template of open market operations, although towards the close of the year, the size of each auction was increased. But markets maange more, so came G-SAP 1.0—an upfront commitment to buy Rs 1 lakh crore in government bonds in the quarter ending June. You can call it repackaged OMOs or you can call it a move-closer-to-QE.

But Why?

At this point you have to ask why the RBI is going above and beyond to keep bond yields, in particular the 10-year bond yield, in check.

The upfront answer to that is to keep government borrowing costs in check. There is much focus on the weighted average cost of borrowing at present. For good reason. As detailed by Business Standard, interest costs now make up a large 52% of central tax receipts. But stomping down yields in one year won’t move that needle.

Yes, it is also true that yield curve in India is steep. At 200 basis points, the spread between the repo rate and the 10-year yield is admittedly wider than the historical average of about 100-150 basis points. But that average masks highs and lows. So in trying to keep long term yields down, the RBI is trying to force down this term premium.

Finally, since government bond yields act as a base for corporate borrowing costs, this also means long-term borrowing costs for the private sector may remain relatively high, although they’re down sharply from pre-crisis times.

There are counters to this.

First, India isn’t the only emerging market which has a steep yield curve right now. From Indonesia to Malaysia, most emerging markets have seen yield curves steepen since December. Long bond yields have been rising across markets on resetting expectations of inflation in the U.S., and India cannot remain immune.

Second, local macros point to higher yields. High government borrowings this year and for the next few years, rising inflation, normalisation of the current account surplus are reason enough for government bond yields to rise.

What Should The RBI Do?

So, should the RBI let go? No one is suggesting that the central bank take a hands-off approach. As it had argued in a recent article in the monthly bulletin, the economy is not ready for higher rates.

So what is the right balance?

First, the RBI’s approach of maintaining adequate liquidity is appropriate. This liquidity has helped bring down borrowing costs for both retail borrowers and corporate borrowers. Here, it is worth mentioning that a number of AAA-rated corporate borrowers are still borrowing at very thin spreads over government bonds and are benefiting from accommodative policies.

Second, the RBI can keep buying bonds, via its open market operations, G-SAP or secondary markets, as per its assessment of liquidity requirements and whenever it notes disruptive moves in the market. But these bond purchases should be driven by liquidity needs and not by the need to maintain a certain level of yield.

Third, the RBI will have to strike the careful balance needed in signaling its tolerance level for inflation and support still-weak growth. If the markets start to believe that the RBI is backing off from its inflation mandate, it will reflect in the bond yields.

Finally, the RBI would do well to remember that while fiscal-monetary coordination is important in difficult times, fiscal dominance of monetary policy, which India has been plagued with for decades, has to be managed within bounds.

Sergi Lanua, deputy chief economist at the International Institute of Finance, sums it up well. “They’ve (RBI) done very well at managing the impact of a global crisis. They definitely have credibility because a year later they can still run loose policies,” he said. “Central banks with a bad track record can’t do that.”

But managing bond yields for a long time will be tough. “6% is a very low level for India’s standards. It is a market outcome under ultra-low interest rates around the world, but most likely not where things will settle in an economy that grows at 5-7% and runs inflation around 4%. Moreover, relatively high debt levels mean a risk premium will be embedded in bond yields,” said Lanua, adding that the central bank can manage these forces in the near term but only in the sense of slowing moves.

Ira Dugal is Editor - Banking, Finance & Economy at BloombergQuint.