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…
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