Why G-Sec yields are stubbornly high?

It has been almost a year since the RBI gave a rude shock to the bond market with its exceptional liquidity tightening measures, raising rates sharply by almost 200 basis points. But after Raghuram Rajan took over as Governor in September 2013, he rolled back most of these measures and rates on the debt instruments, such as certificate of deposit (CD) and commercial paper (CP), quickly cooled off. But the yields on the 10-year Government securities (G-Secs) have not yet relented and have moved up by almost 150 basis points.

While the hike in policy repo rate (the rate at which RBI lends money to commercial banks in the event of any shortfall of funds) appears as the most obvious cause for this anomaly, there are other reasons for the Government still borrowing at higher rates.

The first is the shift in monetary policy’s focus to retail inflation, and the second is the reduction in bond buybacks by the RBI through open market operations (OMOs).

In July, the RBI came out with a slew of liquidity curbing measures. The yield on one year CDs went up by 200 basis points, to 10.8 per cent levels. But as the new Governor started to reverse some of the measures, the rates started to come off. The rates on one year CDs clambered down by almost 180 basis points from September till now. But yields on the 10-year G-Secs continue to be stuck at 8.7-8.8 per cent levels, with no signs of easing.

One may argue that the RBI did raise the repo rate by 75 basis points during this period. True as that may be, the yields on the 10-year G-Sec should have at least come down by 50-60 basis points. This is because while the fixed repo is at a higher 8 per cent, it is not the fully operational rate. Banks’ borrowings under this window are capped at 0.25 per cent of deposits.

With the liquidity situation having improved vastly, banks’ cost of borrowing has actually fallen by 60 basis points from September till now, in spite of the hike in repo rate.

There are two factors keeping yields high. Until Rajan took over, market participants and analysts always looked at WPI inflation to predict RBI’s monetary policy move. Earlier, the comfort zone for the RBI was headline WPI inflation of 4-5 per cent.

Markets are now adjusting themselves to the new target variable — CPI inflation — and this has led to the upward bias in rates.

“It may be recalled that the former RBI Governor D Subbarao cut rates even when CPI inflation was close to 10.5 per cent. Now when CPI has come down by 150 basis points, we are hiking rates. This shift in the nominal anchor for monetary policy to CPI inflation has marked a paradigm shift in the manner in which monetary policy is conducted in India,” says Maneesh Dangi, Co-Chief Investment Officer, Birla Sun Life AMC.

The other reason is that the ready market for G-secs through the open market operations that the RBI does every year has waned. In 2012-13, the RBI did OMOs to the tune of ₹1,50,000 crore. This was close to 33 per cent of the government’s net borrowings that year. However, in 2013-14, this number is down to almost 10 per cent.

According to Dangi, the instrument of providing liquidity is no longer OMOs but forex flows. This has resulted in a demand-supply imbalance in the G-Secs market, which had a ready buyer — the RBI — to the tune of ₹1,50,000 crore almost every year. The market is thus demanding yields of, say, 9 per cent.

The forex reserves are now about $313 billion, significantly up from almost $270 billion in September 2013. With strong flows into the country we may see fewer OMOs for a while. In fact, policies will now have to be framed to tackle excess liquidity, without sending wrong signals to the bond markets.

While sharp rate hikes from hereon are less likely, the yields on the 10-year G-Secs will continue to remain high for some time. Rate cuts are likely when the CPI inflation comes down to 7 per cent levels by March 2015.

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