Bond yields are expected to jump 15-20 basis points when the market opens on Monday, in case the Reserve Bank of India (RBI) decides not to announce any open market operation (OMO) support, to help manage the huge spike in the government's borrowing programme.
On Friday, after markets closed, the government said it would be borrowing Rs 12 trillion for the full fiscal, instead of the originally planned Rs 7.88 trillion, due to the coronavirus (Covid-19) pandemic. Incidentally, earlier on the same day, the 10-year bond yields fell below 6 per cent for the first time since February 2009. The government had also introduced a new 10-year paper with a cut-off of 5.79 per cent.
The borrowing of Rs 12 trillion was “above anything that the market expected,” according to Harihar Krishnamurthy, head of treasury of First Rand Bank. "This move, in all likelihood, push the yields on the new 10 years paper to just about 6 per cent or more," he said.
"However, the banking system's liquidity surplus will also get curtailed due to the heavy borrowing. The government plans to borrow Rs 30,000 crore every week, against less than Rs 20,000 crore originally planned. Risk-averse banks can deploy their Rs 8 trillion plus surplus liquidity in buying these bonds. But short-term rates too, will get pushed up and the yield curve will steepen," said Krishnamurthy, adding rate cuts will have to come even as the last inflation reading was nearly 6 per cent.
While the indicator of slippage in the fiscal deficit was not unexpected, Axis Bank chief economist Saugata Bhattacharya expressed surprise at the magnitude of the proposed use of market borrowings to finance the fiscal gap.
“Given the potential access to alternative sources like T-bills, National Small Savings, etc, these additional borrowings suggests that official thinking the magnitude of the FY21 fiscal gap at this time might be even larger than the Rs 7-8 trillion we have been working with and projected,” Bhattacharya said in a report.
"The bond yields will rise by at least 10 to 15 basis on the borrowing news without any clarity on open market operations (OMO) by the Reserve Bank," said Devendra Dash, head of asset-liability management at AU SFB. "But there would also be buying interest due to the ample free liquidity in the banking system. Eventually, the RBI will have to conduct something like an operation twist, where it buys long term bonds and sells an equivalent amount of short-term bonds," he said.
“RBI is accumulating huge treasury-bills which can be used for such Operation Twists. Hopefully, the extra borrowing may be absorbed by RBI through OMOs, but the timing is crucial,” Dash said. He expects the RBI to announce OMO of Rs 2-3 trillion.
Rate cuts can still happen, “but long bonds won't benefit,” said Badrish Kulhalli, head of fixed income at HDFC Life. “Only OMO, or Operation Twist will help. Markets will look for RBI support for almost all of the additional borrowing,” Kulhalli said.
The RBI also has other options like capping how much banks can park in the reverse repo, and forcing them to buy bonds instead. Besides, the RBI also has options like the standing deposit facility (SDF), in which the RBI receives the surplus liquidity without any collateral at a lower rate than reverse repo to fight excess liquidity, but that might not be needed ultimately as the banks will now use up their liquidity to buy government bonds.
There are also state government bonds, vying for the same surplus liquidity. Between the centre and the states, the total borrowing could easily rise to Rs 20 trillion, and crowd out private corporate borrowers.
However, the huge surplus liquidity is not the new normal. It has a shelf life, and will go away in a few months. The incremental liquidity creation will likely get adjusted with a reduction in ways and means advances and by normalization of the cash reserve ratio in the second half, according to Soumyajit Niyogi, associate director at India Ratings.
“Conducting an OMO purchase when the liquidity surplus is above 5 trillion, could create a signal extraction problem and affect the central bank's credibility. It's better to buy directly in the secondary, or primary market, for the avoidance of unwarranted announcement effects,” Niyogi said.