Link between interest rates and yield has broken down, say experts

Monetisation of sovereign debt, which is just like printing money to fill the gap in government finances, is being proposed as a way to bring down the yield on government securities (g-secs), experts say.

With the government facing a record-high deficit in its finances, the recent increase in market borrowings has resulted in an oversupply of g-secs, and a fall in prices. Yield, which is the ratio of interest paid and price, moves in the opposite direction of price movement.

But the negative fallout of this monetisation of debt will be an increase in inflation because of a rise in money supply. Although, with headline inflation at record-low levels, this may not be of immediate concern. However, the government has to secure the approval of the Parliament before it can borrow directly from the Reserve Bank of India (RBI) as per Fiscal Responsibility and Budget Management (FRBM) Act.

“Yield on g-secs have not softened because of supply side pressures (referring to the expected increase in government borrowing)”, said Indranil Pan, an economist with Kotak Bank. “One way to reduce the supply would be to monetise the debt.”

The combined fiscal deficit is expected to cross 10 per cent of India’s output in the current and next financial years, as the ongoing economic slowdown translates into a lower growth in tax revenues and higher spending to stimulate growth. The combined borrowing of the Centre and the states is expected to touch the Rs 5,00,000-crore mark in fiscal 2010.

Already, with a high level of borrowing, experts say the link between key interest rates fixed by the central bank and yield has broken down. For example, from mid-September, repo rate was reduced by 3.5 per cent till December 2008.

The yield on benchmark 10-year government bonds responded equally by falling by 3.45 per cent.

However, since January 2009, the yield has not responded to the reduction in repo rates by RBI. As against a 1.5 percentage point reduction in repo rate, the yield has increased by nearly 1.3 percentage points.

This breakdown in the relationship between repo rate and yield is evidence of a weakening monetary policy effect, said D K Joshi, an economist with Crisil, a ratings and advisory firm.

Another impact of the increased borrowing is crowding out of private sector borrowing. The spread between g-secs and corporate bonds had widened to as high as 600-700 basis points (one basis point is one-hundredth of a percentage point) two months back. The difference is now hovering around 400 basis points.

Offering a different view, Golaka C Nath, vice-president of economic research at Clearing Corporation of India, which maintains data on g-secs trading, said, “Over a period of time, even monetisation of debt would not help as the markets would factor in this additional private placement between the government and RBI”.

(With inputs from Swapnil Mayekar)