A rise in sovereign bond yields means a rise in the interest rate in the economy
If the interest rates rise, banks make their lending rate costlier
The 10-year bond yields touched 6.20 per cent on Monday, the highest since April 21, 2020. In the ordinary course of things, this may not sound much, but the Reserve Bank of India (RBI) has tried very hard to keep the yields below 6 per cent in this fiscal to enable the government to borrow cheaply. Bond investors obliged the RBI, but after the Union Budget this year, the mood has soured. The implications of a bond market strike can be quite negative for the economy. Here’s why.
Why are the bond yields rising?
The primary reason is oversupply of bonds. The government, in its Budget on February 1, announced Rs 80,000 crore extra borrowing for this fiscal and Rs 12.05 trillion of gross market borrowing for the next. In the current fiscal, the government has already borrowed more than Rs 13 trillion from the market and the states an additional Rs 10 trillion. Major investors in the bond market are banks, insurance companies and provident/pension funds. Foreign investors hold less than 5 per cent of the outstanding stock. Clearly, as supply outmatches the demand, the investors are offering lower prices for the bonds. When bond prices fall, yields rise.
Why is a rise in yields a concern for everyone?
A rise in sovereign bond yields means a rise in the interest rate in the economy. If the interest rates rise, banks make their lending rate costlier. The market also demands higher interest costs for the companies that want to issue bonds to meet their financing needs, as well as for the government. The interest is a crucial input cost, and this pushes up overall cost in the economy. When the pricing power is constrained due to low demand, a rising cost squeezes the profit, discouraging entrepreneurs to invest in the economy. The government also cannot spend enough on infrastructure and other social expenses. People defer their discretionary spending, and put off car and house purchases. All of these combined bring the economic growth down, and ultimately spirals into job losses and all kinds of economic maladies.
What impact will the rising yields have on the banks and the government?
For most part of fiscal 2020-21, the 10-year bond yields were below 6 per cent. Now if the yields rise to, say, 6.20 per cent by the end of the quarter, that’s a loss for banks on their bond holdings which they must show as treasury losses. Banks will simply stop buying bonds if they are threatened with such losses. The government will not be able to borrow cheaply in that case.
For the government, any fresh bond issuance has to be done at near the market yields. If the yields increase in the secondary market, the fresh issuance has to be done at a higher interest rate. This increases the interest cost for the government substantially. Therefore, the RBI will try to keep yields low, because it sees low yields as a “public good”.
What is the RBI doing to address this?
The RBI is refusing to sell bonds at the yields markets are quoting. At the same time, it is buying huge amounts of bonds from the secondary market, both pre-announced and unannounced. So far, this fiscal, it has bought bonds worth Rs 3.04 trillion. The markets are, however, expecting the RBI to buy bonds every week so that they can offload old bonds and buy fresh ones. Whenever the RBI is silent on a bond buyback, the yields get pushed up.
So, what tools does the RBI have to cap the yields?
The RBI has no dearth of tools, but the most effective one right now is simply to keep on buying more bonds. There is also a theory that there are short-sellers in the market. The yields can come down rapidly if the short-sellers are discouraged. The RBI can also let the banks buy more bonds and hold them till maturity. And the RBI can stop normalisation of liquidity operations and let the investors use the easy liquidity to buy bonds. The central bank is not afraid of being innovative when the situation so demands.
If the RBI is buying the bonds anyway, why can’t it do so directly from the government?
Such “direct monetisation” of fiscal deficits is not allowed since the 1990s. But the RBI is doing so indirectly. In the past three years, this has increased substantially. Basically, the RBI is acting as another class of domestic investor in the market and expanding its balance sheet. The problem is that this operation releases a huge amount of liquidity into the system, which can stoke inflation if it is not managed carefully. High inflation is potentially far more dangerous than rising bond yields, and the prescription to come out of high inflation is raising interest rates further.