A yield problem

Sharp increase in G-sec yields throws up questions

In the course of just six months or so, India’s sovereign yield curve has steepened sharply. In other words, differences between the repo rate, the policy rate targeted by the Reserve Bank of India, and the long-term rate of return on bonds have grown. While the RBI has maintained the repo rate, bond yields have gone up swiftly. At the end of the calendar year, the yield on the 10-year government securities (G-sec) hit 7.4 per cent, which is an increase of 100 basis points since July of 2017. The implications for the economic revival going forward are considerable and worrying. India Inc. has become increasingly reliant on the bond market for funds that a strained and under-pressure banking system has proved unwilling to disburse. The last straw must have been the news that the government plans to borrow an additional Rs 500 billion before the end of this financial year. This put the fiscal deficit target in doubt and added to concerns about an over-supply of government paper. Decisions by the RBI on whether or not to carry out scheduled auctions are watched ever more carefully because of the impact that additional supply would have on portfolio yields.

This phenomenon throws up several questions that the government and the RBI need to find answers to. First of all, going back to first macroeconomic principles, if the long-term interest rate diverges sharply from the short-term rate, it means that there are significant doubts in market participants’ minds about the future path of short-term interest rates over time. Ideally, instruments of monetary policy other than the short-term policy rate need to be examined. It is widely accepted that debt management policies — finding an optimal mix of maturities for government bonds — become more effective as an instrument when short-term interest rates become less effective. What is the current mix? At the end of the July-September 2017 quarter, 28 per cent of the outstanding stock of government debt had a residual maturity of up to five years. There needs to be more transparent and substantive discussion about how active debt management can complement the RBI’s use of other instruments.

The steepening of the yield curve is also a warning to the government. It is not wise, at this point, to give in to demands for over-spending prior to the next general elections — particularly since revenue projections post the introduction of the goods and services tax continue to be so uncertain. At the moment, US interest rates are low. But there is no question that at some point they will begin to tighten; unless domestic yields have settled down by then, India might see significant capital flight. The effects of this, both economic and political, should be clear from the fallout of the “taper tantrum” of 2013. Other macroeconomic indicators are also showing signs of turning adverse. The government thus has a careful path to walk in 2018. It must continue to find ways to stimulate the recovery while being mindful of the grave dangers of excessive borrowing for macroeconomic stability.