The 10-year government bond yield is a benchmark that determines the interest-rate environment in the debt market. While there are several bonds traded in India, this bond attracts the most attention. Since June, its yield has stubbornly stayed in a 6.40-6.60% range. This is notwithstanding the fact that the Reserve Bank of India (RBI) has been lowering its repo rate, which ought to have pulled down bond yields.
This divergence would not be an issue if it did not affect interest rates beyond the market for government securities (G-Secs), such as the rates of bonds issued by state governments and corporations.
But all bond yields are benchmarked with what G-Secs offer. Hence, depending on the spread that must be offered above G-Sec rates (as a risk premium), they need to be priced accordingly. States lament that their cost of borrowing has gone up. Corporates too have to pay higher rates, even as bank loans have gotten cheaper.
We face an anomalous situation. Banks perforce have to lower lending rates when the repo rate is lowered, as several of their loans are directly linked with repo movements. The system of external benchmark lending rate (EBLR) is unique to India, mandating that some loans be tied to an external benchmark. Hence, when the repo rate falls, so does the lending rate. The idea is to ensure swift policy transmission.
Banks are then compelled to also lower their deposit rates to protect their margins. When this is done, the basic component for calculating the marginal cost lending rate (MCLR) also comes down.
But the market works on various decisions taken by banks, mutual funds insurance companies, primary dealers, market makers and others. While banks, which are major players in the G-Sec market, lower their rates as they must in a regulated system, the market does not always accept lower rates.
There are reasons for stubborn bond yields. The government’s borrowing programme has increased the supply of G-Secs, which lowers their prices and raises yields. RBI, the Centre’s debt manager, has indicated that central borrowing will not exceed what was budgeted; this also holds for states.
Yet, given the tight liquidity situation—typified by weak deposit growth as interest rates have dropped—the reverberations have been felt in the bond market. Low deposit rates have led to shortfalls in liquidity that necessitated RBI relief.
RBI has done much to assuage yields, albeit indirectly. Banks’ cash reserve ratio has been cut, like the repo rate. Open-market G-Sec purchases have been announced and carried out to inject liquidity. Fewer bonds available in the market should have pushed up their prices and lowered yields, but this has not happened.
Curiously, bond yields rose after RBI’s June policy, when it was stated that there was a limit to which the repo rate could be cut to support economic growth. The 10-year G-Sec’s yield rose from 6.26% on the eve of that policy to 6.40% by the next policy announcement in August and then to 6.50% in October. Since then, it has hovered around 6.60%, a new normal.
The RBI policy of December effected a repo rate cut, even as the central bank announced bond buybacks and indicated that there could be more rate cuts if needed. A probable point to debate in the December policy was that bond purchases were announced with the aim of providing liquidity rather than influencing bond yields directly. This may have made the market think that the prevailing yield range is acceptable.
Now, if a contrarian hat is put on, a different narrative can be expounded. Had yields stayed steady in a range of 6.50-6.60%, perhaps it would indicate that this is a fair level.
A corollary would be that trying to bring down yields now would not be possible, given how the ‘invisible hand’ of the market has yielded this result. An extension would plausibly be that a repo rate of 5.5%, which is what it was in June, is consistent with macroeconomic stability. This would also imply that the December repo cut could have been eschewed.
The cliched Goldilocks situation, where growth is high and inflation low, has made it hard to interpret how things should go. By the December logic of lowering the repo rate to support growth, there would be a case for another rate cut in February and perhaps also in April, as GDP growth is expected to fall to under 7% while inflation stays within RBI’s target band. In such a scenario, how much more can rates be lowered?
This is where the market voices itself through bond price movements. Bond yields, which are supposed to price in all information on growth, inflation, the fiscal situation, supply of liquidity and other factors, have been steady over the last six months. This can be interpreted as a vote in favour of the present yield range. If so, a repo rate of 5.5% would be ideal, implying a spread of around 100 basis points for the 10-year G-Sec.
Bond yields can serve as an important signal while setting the repo rate if one accepts that the ‘efficient market hypothesis’ is at work. A thought worth pursuing is whether one can use the 10-year bond yield as an indicator for monetary policy. Since our financial conditions have departed from convention, this is worth thinking about.
These are the author’s personal views.
The author is chief economist, Bank of Baroda, and author of ‘Corporate Quirks: The Darker Side of the Sun’.
