For a long time, market-watchers in India have thought of India’s stock market as a rule-breaking juvenile, while the bond market has remained its obedient sibling. But the bond market is now following in the footsteps of its unruly sibling.
In the last couple of years, market interest rates have gyrated sharply without waiting for the Monetary Policy Committee’s (MPC’s) bi-monthly decisions on rates. Banks, which used to jump through hoops when the Reserve Bank of India snapped its fingers, have developed a mind of their own too. This could have important implications for investors, policymakers, depositors and India Inc.
Don’t mind the MPC
Students of economics have always been told that it is the RBI (and lately the MPC) which ‘sets’ benchmark interest rates for the Indian economy. Trends in market interest rates in the last three years demolish this myth.
Throughout 2014, despite mounting pressure to cut rates, RBI doggedly held its repo rate at 8 per cent. Market interest rates, however, decided to jump off a cliff, with the yield on 10-year government security — the most-traded bond in the Indian market — crashing from 8.8 per cent to 7.8 per cent. In January 2015, the RBI finally gave in. Between January and October 2015, it slashed its policy rate by 125 basis points to 6.75 per cent. But market interest rates barely budged.
After three more repo rate cuts to 6 per cent in August 2017, the MPC has been sitting on the fence for the last seven months. But the 10-year g-sec, anticipating a reversal, has zoomed up by 130 basis points to rule at 7.7 per cent. Yes, one may argue that long-term interest rates in any bond market ought to trade at a premium to overnight rates. But more than the quantum of these market moves, it is their diverging direction from the MPC, that bears watching.
With sovereign bonds doing an about-turn, interest rates in the rest of the market have followed suit. Since August 2017, market yields on 5-year AAA-rated corporate bonds have shot up by 90 basis points to 8.1 per cent and 3-month commercial paper has seen rates spike by 130 basis points to 7.9 per cent. In other words, borrowing costs for both the Government and India Inc have risen by anywhere between 80 to 130 basis points, without the MPC making any changes to its ‘benchmark’ rates.
Given that bond markets and not banks accounted for over 60 per cent of commercial lending in FY17, it is the rate moves in the market, and not those of the MPC, that decide borrowing costs for India Inc. Investors in NCDs, tax-free bonds and debt mutual funds can also do better by tuning in to bond markets, rather than following the MPC.
If setting repo rates was just one of RBI’s tools to steer interest rates in the Indian economy, the other major weapon in its armoury, was its role in orchestrating the Government borrowing programme.
Banks break free
As the sole supplier of prized g-secs to the market, the RBI has always been able to influence long-term interest rates by tweaking the maturities and cut-off rates of g-secs that it auctions off at periodic intervals. Over the years, this has helped the RBI keep a tight lid on the Centre’s borrowing costs despite a growing debt pile.
Historically, Indian banks have been the biggest buyers in RBI auctions, thanks to their 19.5 per cent Statutory Liquidity Ratio (SLR) requirement. As banks tend to be captive buyers of g-secs, dwarfing other bidders such as insurers and pension funds, the RBI has held the upper hand on deciding g-sec maturity profiles and rates.
But the last three months have seen an unusual drama play out in RBI auctions. While the RBI has been trying to sell long-dated g-secs at lower-than-market rates, auction bidders have dug in their heels demanding higher rates. This is largely because banks, already holding far more than the required quantities of SLR (about 30 per cent) and taking big losses on them, have been lukewarm to the auctions.
After three or more cancelled auctions, if the RBI is now to get rid of its unsold stock of g-secs for FY18, it may have to reduce their maturities, raise the rates offered or coax banks into playing ball.
It isn’t clear yet if Indian banks’ retreat from g-secs is a tactical or a strategic one. But recent events do suggest that the Centre may now have to pay heed to the bond market’s views while setting its annual deficit and borrowing targets, instead of relying on RBI to ‘fix’ its borrowing rates.
Not so long ago, banks used to be loath to tweak either their deposit or lending rates without the MPC leading the way. But this seems to be changing too.
Since November 2017, tightening liquidity conditions and improving credit offtake have prompted leading banks to up their bulk deposit rates by a sharp 50-140 basis points, even as the repo rate has remained on hold. With deposit rates climbing, banks’ Marginal Cost of Funds Based Lending Rate (MCLR) cannot be far behind.
In the last couple of months, leading banks have also pegged up their lending rates 10-25 basis points, again without the say-so of the MPC. Clearly, even retail depositors and borrowers are now better off tracking market interest rates, rather than MPC actions.
Why the wedge?
But what are the factors driving a wedge between market interest rates and official rates? And do recent trends signal a coming of age of the Indian bond market or is this a temporary tantrum?
There are no clear answers as yet. Both temporary and structural factors have triggered recent bond market behaviour.
For one, unlike the RBI which used a multiple-indicator approach to decide on rates, the MPC since inception has adopted a single-minded focus on inflation readings.
The bond markets however, continue, to react dynamically to a host of other factors — global trends in oil, commodity price cycles, rate actions by the US Fed and so on. Then there’s liquidity too — the all-important demand-supply dynamics for bonds of different tenors. If these factors are more supportive of rate increases, it is quite logical for bond markets to run ahead of MPC. Lately, the MPC has also been wrong with its inflation forecasts, allowing the markets get ahead of the curve.
Two, as bond markets attract more investors such as FPIs, mutual funds and market-linked pension funds who take a more active investing approach than domestic banks, bond prices are bound to turn more volatile and responsive to global trends. G-sec ownership by non-banks has edged up from 30 to 34 per cent in the last four years, with these players now accounting for a significant portion of daily trades.
Whatever the reasons, if India’s bond market rebellion continues, investors, borrowers and India Inc should all prepare for more unpredictable swings in interest rates.
But they can take heart from the fact that even the Government can no longer go on a borrowing binge without paying a price for its profligacy.
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