RBI must be mindful of inflation risks of higher borrowing
All is not well in the Indian bond market. The Reserve Bank of India (RBI), which is also the government’s debt manager, is unwilling to let yields on 10-year Central government bonds go above the 6 per cent mark. But investors are demanding higher yields and are not ready to buy government bonds at the given price. As a result, the central bank has not been able to sell a large proportion of government bonds in recent weeks and is being picked up by primary dealers. The yield on 10-year government bonds in the market has gone up from about 5.8 per cent at the beginning of the year to 6.2 per cent. To be fair, the visible anxiety in the bond market is not unwarranted.
As the economy is returning to normal after an unprecedented disruption caused by the Covid-19 pandemic, the central bank will also need to roll back some of the emergency measures. For instance, the reduction in the cash reserve ratio will be normalised in two phases. This will affect liquidity in the system and push up the cost of money. Further, the supply of government bonds has increased significantly. The Central government is borrowing about Rs 12.8 trillion in the current fiscal year. The borrowing for 2021-22 has been estimated at about Rs 9.7 trillion, which is over 50 per cent higher than in 2019-20. Besides, the market will also have to absorb the bonds of state governments and other public sector entities. Other things being equal, a substantial increase in supply is bound to affect the price. Thus, what is happening in the bond market is not unusual.
Additionally, against the mandated statutory liquidity ratio of 18 per cent, commercial banks have reportedly accumulated government paper worth about 30 per cent of their net demand and time liabilities. It is highly likely that banks buying government securities at lower yields would suffer mark-to-market losses in the coming months. Perhaps the only way the RBI can keep yields at a lower level is by infusing large doses of liquidity through open market operations. But this path is not without risks. Higher liquidity in the system for an extended period of time could result in higher inflation. Yield-targeting can also send a signal that the central bank is not worried about inflation and is prioritising government borrowing, which can fuel inflation expectations. Although inflation has moderated after overshooting the upper tolerance band for six months, there are risks. Core inflation, for example, remains elevated. The upswing in global commodity prices — including those of crude oil — could push up the inflation rate.
The RBI clearly has to engage in a tough balancing act. As the Monetary Policy Committee member Mridul Saggar noted at the last policy meeting, if the central bank intervenes moderately through open market operations, there is a risk of crowding out private investment. Additionally, debt funds too can be adversely impacted. But if the interventions are large, they can trigger inflation. Therefore, in the given situation, the central bank should not adopt a rigid position. It needs to ensure that there is adequate liquidity in the system, but allow bond yields to go up, which will appropriately compensate financial investors. The government should also accept the message from the bond market and be prepared to pay a higher price for a substantial increase in borrowing. Sustained yield management by excess liquidity infusion can increase inflation risks and affect policy credibility with longer-term consequences.