In an interview with a TV channel last Friday, Reserve Bank of India (RBI) Governor Shaktikanta Das reiterated the central bank’s commitment to growth and financial stability, saying it is battle ready. All conventional and unconventional, and even “new” weapons, are on its table, he said. It will use anything and everything, if required.
Das also said that as the government’s debt manager, the RBI would ensure the completion of market borrowing in a “non-disruptive” manner.
Hours after the interview, the debt manager had to settle for higher yields to see through three auctions of government bonds, maturing between five and 30 years, raising Rs 32,000 crore, including a Rs 2,000-crore green shoe option. It was a classic case of chasing the tail – going for lower cut-off prices to make the auctions sail through.
Those who bought the securities rushed to sell the bonds in the secondary market to cut losses, bringing the prices further down and pushing the yields up.
The 10-year benchmark yield is now above 6 per cent. There are three 10-year papers being traded in the market – all liquid – and the yields of all three are higher than 6 per cent.
In a fortnight between August 5 – a day before the last RBI policy where its Monetary Policy Committee (MPC) decided to keep the policy rate unchanged – and August 21, the 10-year paper yield has risen at least 30 basis points (bps — one bps is a hundredth of a percentage point). The rise in five-year bond yield is even higher – more than 40 bps. At the shorter end, the 364-day treasury bill yield, however, is just marginally up in the past fortnight.
Incidentally, in the previous week’s auction, Rs 4,637 crore devolved on the primary dealers as there weren’t many takers for government bonds at the price the RBI was selling them for. If the devolvement sent a signal that the government’s debt manager was not willing to see the bond yields hardening, the Friday auctions confused the market. Not only did the RBI settle for a higher yield but it also exercised the green shoe option to raise Rs 2,000 crore extra. This, in fact, redefines “green shoe” option, which is exercised when the demand for a security is far higher than expected.
Why have the bond yields been hardening when there is at least Rs 3.75 trillion excess liquidity in the system? And, when the RBI is willing to do anything it takes to ensure a non-disruptive market borrowing by the government?
When I posed this question to a bond dealer, he said: “Half way across the river, if the boatman asked you, ‘Do you know how to swim?’, how would you react?” What he meant was that the RBI has left its job half finished. Since March, it has cut the policy rate by 115 bps to it historic low and flooded the system with money, opening many windows. That’s fine. But it is not doing more — what it has been promising.
The RBI’s wait-and-watch mode is creating cracks in the market’s confidence. Unless the central bank starts buying bond through the so-called open-market operations and resumes operation twists (simultaneous buying of long-term securities and selling of short-term papers), bond yields will harden further. To bring that down, it would have to work much harder later if it doesn’t act now.
For the current year, the government borrowing programme has been raised from the budgeted Rs 7.8 trillion to Rs 12 trillion to bridge the higher fiscal deficit. In the first half of the year, so far Rs 6.16 trillion has been raised, including the green shoe options, on top of the regular auctions. Also, Rs 2.33 trillion flowed through one-year treasury bills and the RBI has bought bonds worth at least Rs 1.44 trillion through open-market operations.
Even though the Indian central bank is continuing with its dovish stance and is willing to do everything to ensure smooth sailing of the government borrowing programme, the observation of RBI Deputy Governor Michael Patra, one of the key MPC members, is pretty bearish. According to him, the “outlook is grim” and “if inflation persists above the upper tolerance band (6 per cent) for one more quarter, monetary policy will be constrained by mandate to undertake remedial action”. The average retail inflation in the first quarter of 2021 has been 6.5 per cent, and is rising.
The RBI’s unwillingness to estimate inflation and growth projections for the year, too, is adding to the uncertainties. Like everyone else, isn’t the RBI convinced that the inflation will come down to around 4 per cent by the end of the financial year? If it is and it says so, that will soothe the frayed nerves of the bond dealers.
If the bond yields continue to rise, the monetary transmission, which has been happening fairly well since the March rate cut, will halt. The policy rate could be at its lowest but it would not mean anything for the cost of money for the borrowers.
What will be the overall impact?
# First, the government’s cost of borrowing will increase, putting pressure on the widening fiscal deficit.
# Second, the corporate bond market will trail the rising government bond yields, raising the cost of money for private entities and dampening their willingness to make fresh investments.
# Finally, this will also affect the banks’ balance sheets. Historically, treasury income is a currency that helps banks cushion the impact of rising bad loans that dent their interest income. It’s no secret that their bad loans will rise but the treasury income will not come to the bank’s rescue. Many will end up booking treasury losses.
Then, there will be mark-to-market, or MTM, losses. (MTM is an accounting practice of valuing the bond portfolio at the current market price and not the price at which they were bought.) The banks won’t be able to escape the MTM losses as the bond prices are slipping (and yields rising).
The RBI can protect the banks’ balance sheets by reshuffling their bond portfolio and raising the level of the so-called “held to maturity”, or HTM, basket, which is not exposed to any risk of rising interest rate. But successful monetary transmission will not happen unless it acts. Mere talk won’t bring the bond yields down.