RBI faces uphill task as bond yields stay stubborn amid weak demand

The Reserve Bank of India (RBI) seems somewhat uncomfortable with the prevailing bond yields. The auction of 10-year government bonds worth ₹32,000 crore went through last week, but the RBI had cancelled the auction of seven-year government bonds earlier this month because investors were demanding higher yields. Further, as reported by this newspaper, the central bank has suggested to state governments to reschedule their borrowing to ease the supply pressure. Recently, Maharashtra rejected all the bids for certain bonds. It is worth noting here that the Monetary Policy Committee (MPC) of the RBI has reduced the policy repo rate by 100 basis points this year, but yields on the benchmark 10-year government bonds have declined by only about 30 basis points. Yields on 10-year bonds have gone up by about 20 basis points since the rate cut of 50 basis points in the June policy.

 

Since yields on government bonds directly affect the cost of money in the financial system, it can be argued that the transmission of policy rate cuts has been weak. The RBI has also injected liquidity into the system with a 100-basis point reduction in the cash reserve ratio, which is being implemented in four tranches — the last one is due for the fortnight beginning November 29. Thus, it is worth debating why the debt-market movement has not been in line with policy expectations, and what this means for fiscal and monetary policy.  A recent note by IDFC Bank, for instance, said liquidity in the banking system has been running below the threshold of 1 per cent of net demand and time liabilities since September. The level of liquidity has declined, partly owing to the RBI’s intervention in the foreign-exchange market. Thus, a lot will depend on how the RBI deals with liquidity. It has also been reported that some banks are sitting on mark-to-market losses and are not keen on buying large quantities of bonds. Slow deposit growth could also be a factor. 

The demand from foreign portfolio investors (FPIs) too seems muted. FPIs brought Indian bonds worth only $1.2 billion net this year thus far, compared to $12.6 billion during January-November last year. Further, the net supply of bonds is expected to be higher in the second half of the year compared to the first. Given the prevailing bond-market conditions, any further reduction in the policy repo rate, as anticipated by several market participants, may likely have a limited impact on the cost of funds. Yield movement will depend also on how both the financial market and the central bank expect the inflation rate to move in the coming quarters, because it will determine the durability of a potential rate cut.

 

The consumer price index-based inflation rate declined to 0.25 per cent in October. However, the last meeting of the MPC projected the inflation rate to increase to 4 per cent in the last quarter this financial year and further to 4.5 per cent in the first quarter next financial year. The tightening of bond yields also has a signal for fiscal policy. Although the government has credibly reduced the fiscal deficit over the past several years, particularly after the pandemic spike, the general government borrowing requirement is still on the higher side. Revenue collection thus far suggests meeting the fiscal-deficit target in the current year could be challenging. Further, the Union government will move to target the debt level from next financial year, which may mean that the fiscal deficit will not decline systematically as has been the case in recent years, and markets may need to adjust.