RBI’s rescue act

But bond market remains jittery as capital outflows hit a high

At the moment, few things seem capable of dissipating the gloom that has descended on India’s bond markets. In its latest effort to cheer up the market, the Reserve Bank of India has announced that it will buy bonds worth ~100 billion on May 17, in order to meet “durable liquidity needs going forward”. The RBI’s motivations are understandable; the benchmark yield on government debt has shot up in the past year, and is now touching a very dangerous 7.8 per cent — it was 6.35 per cent at the time of demonetisation in November 2016. Since then, a number of factors have helped send up yields. For one, the Union government has shown itself willing to tolerate some fiscal slippage, a change from its past faithfulness to the path of deficit consolidation. In addition, the markets have been flooded with sovereign and quasi-sovereign paper just as demand stumbled following the public sector banks’ increasing unwillingness to mop up government debt, which is causing them treasury losses. Finally, inflation looks set to return, driven not just by domestic factors but also the uncertainty about the path of crude oil prices.

There was some hope on the RBI’s behalf that greater openness to foreign portfolio investors (FPIs) would help send down bond yields. As a result, the RBI recently announced — after consultation with the Securities and Exchange Board of India or Sebi — a series of measures that it said would liberalise the purchase of bonds by FPIs. Among these measures were an apparent relaxation of the minimum residual maturity period requirement and crucially an increase in the limit for FPI investment in central government securities. However, the market did not react with any great excitement to the announcement. This was partly because it was not, in fact, a case of liberalisation at all. The residual maturity requirement was replaced by a stringent requirement that investment in securities of any category with residual maturity less than a year must be 20 per cent or less than of the FPI’s total investment in that category. In addition, the RBI introduced “concentration” requirements, which have put off many investors; among other things, an FPI could not buy a majority of any issue of a corporate bond. The market saw these and other requirements as detached from ground realities and counter-productive. Thus the tendency of FPIs to abandon the Indian capital markets will likely continue in May. April saw ~90 billion flow out of the debt markets — the total outflow of ~155 billion was the highest in 16 months.

The RBI has been forced into a rearguard action, defending the currency. The central bank’s foreign exchange reserves decreased by $3.22 billion in the week to April 27, after having fallen by $2.5 billion. Of course, the RBI is entitled to stabilise the currency’s movements, but it must avoid being seen as attempting and failing to fight the markets. The bond markets have judged the macroeconomic and fiscal situation and have not done so favourably; the central bank’s attempts so far to stem the movement of capital are unlikely to alter that judgment.