A premature tightening
There is no fundamental reason for bond yields to stay at elevated levels. But waiting for the market to self-correct could be costly for the economy
At just about the same time that India’s economic growth has started to pick up from the recent trough, monetary conditions have begun to tighten. For those dependent on the bond market, conditions have already tightened sharply, with interest rates up by nearly a per cent and a half. They are no longer a minority: in the last financial year, nearly five trillion of the seven trillion rupees of incremental credit was funded outside the banking system. Even bank funded entities may now expect higher rates, with the bellwether State Bank of India (SBI) now raising lending rates by twenty basis points.
Bond yields have risen so sharply that an observer only looking at bond yields would assume the economy was in crisis. The move in the last six months has been one of the worst in recent memory, and reminiscent of the “crisis quarters” in 2013, 2008 and 2009.
“Explanations” for this move range from attempts to read forward-looking signals (“if the economy is really turning the corner, should the yields not be rising?”), to pointing to the rise in global bond yields, the spurt in consumer price inflation, and concerns about significant fiscal slippage, heightened by the recent spike in crude oil prices and approaching general elections. None of these holds up to scrutiny, in our view.
Even the unexpectedly strong GDP growth in the December quarter is far below what the economy has seen in the past, and it may be premature to be concerned about inflationary pressures at this early stage of economic recovery. In fact, the gap between yields on the ten-year government bond and the repo rate set by the Monetary Policy Committee (MPC) is at alltime highs, higher even than during the panic-stricken months in mid-2013. If this gap were to fall to average levels, either bond yields must fall by a per cent or the MPC must hike rates by that amount.
As the MPC’s target is inflation, that would require inflation to stabilise at around six per cent, compared to the sub-five per cent levels we have seen for the last two years. Inflation is in fact on its way down, with prices of onions and tomatoes, the prime drivers of the pickup in headline inflation in the last few quarters, correcting sharply with the new harvest. Some concerns have emerged recently with the Union government’s new formula for setting minimum support prices, likely because it signals a change in policy priorities, from controlling inflation at all costs to trying to guarantee farmer profitability. However, even if the government were to be successful in boosting farm-gate prices, end consumer prices are unlikely to be affected, in our view, given surpluses in nearly every food category.
Similarly, it is hard to find a causal link that can keep the gap between Indian sovereign bond yields and US treasury yields constant. Less than five per cent of Indian government bonds are owned by foreigners and in the middle of the last decade the US and Indian government bond yields were similar. The recent sharp rise in US bond yields has been driven by changing expectations on several fronts, including on rising wages, and a sharp increase in the US fiscal deficit.
There have also been concerns about fiscal slippage in India and in particular about the government’s estimates of the Goods and Services Tax (GST) collections in the coming financial year. This is surprising, as the estimates appear benign if not conservative, particularly given the sharp nominal growth seen in sectors like metals, plastics and chemicals that contribute significantly to indirect taxes. Corporate income tax collection projections also seem to be lower than the market estimates of profit growth in the coming year. More importantly, at a broader level, any analysis linking fiscal deficits to bond yields must focus on the combined borrowing by central and state governments: one must note that the much feared deterioration in state government deficits did not transpire this year.
Thus, we believe there is no fundamental reason for bond yields to stay at these elevated levels. It appears that illiquidity in the bond market is exacerbating the volatility. Public sector banks, which in late October last year were promised a capital infusion by the government, started shedding their holdings of government bonds (they held more than statutory requirements) to create space for increasing loans. As this forced bond yields up, incremental lending started to move back from the bond markets to banks, forcing more selling of these bonds. They also became less willing to participate in government bond auctions. As banks hold nearly two-fifths of all outstanding government bonds, when they turned net sellers instead of buyers, the rest of the market could not (and cannot) offset the demand shortfall.
This episode shows that even as the process of disintermediation of the banks has proceeded in line with policy priorities, the apparatus to monitor and stabilise the all-important government bond yield is still evolving. A clear example was the date of the announcement of additional borrowing by the Union government—two days before the quarter ended on 31 December, which forced heavy mark-to-market losses on banks—only for the quantum to get revised down three weeks later.
There are undeniable merits in the purist approach advocated by some of not targeting prices of securities, and just ensuring that short-term rates reflect the repo rate. However, as market mechanisms evolve, and systemic immaturity results in inadvertent tightening, inaction can be damaging. More so as recent policy changes that target breaking the bank-promoter nexus may already be driving reluctance among government-owned banks to lend. Recent scandals in trade financing are also moving some external borrowing back to the domestic market.
The fall in bond prices (higher yields mean lower prices) has also directed more financial savings to equities, which in pockets were already becoming frothy. This at a time when formal credit penetration is still worryingly low, and the rise in funding costs could slow down the expansion of bond-market funded financial firms. Misallocation of savings in the economy is not only unproductive, but also damaging.
As financial savings in the economy continue to rise, inflation stays in control, and government borrowing needs from the bond market remain under control, bond yields should reach where they fundamentally should be. However, it is unclear whether the time taken to reach such an equilibrium would be what the economy needs.
The author is India Equity Strategist for Credit Suisse