Four months ago, when central bank governor Shaktikanta Das looked for “cooperative solutions” in the bond market, the intention should have been clear. The Reserve Bank of India (RBI) wanted bond investors to increase their appetites to accommodate the government’s massive borrowing program. also wanted them to do it at a cheaper cost.
Anyway, Das wanted to have the cake and eat it too. He wants the supply of government bonds to pass and also wants prices not to fall or yields to rise. It shouldn’t surprise us that the plan is not working well. The yield on benchmark 10-year bonds is currently well above 6%, a level at which RBI tried to hold bonds a few weeks ago. Analysts at Crisil Ltd expect the 10-year bond to reach 6.5% by March 2022, while some in the bond market believe the 6.25% level is not far off. The 10-year bond yield ended at 6.17% on Tuesday. “Overall, we believe that supply pressures will impact the 10-year yield of the G-sec once the RBI begins to undo its ultra-accommodative monetary policy,” Crisil analysts said. in a note.
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The supply of bonds is huge, and simple economics will tell us that when the supply exceeds demand, prices go down. In the case of bonds, yields increase when they move inversely with prices. Simply put, the greater the supply of bonds, the more yields will rise. RBI hopes to get around this logic a bit by participating as a buyer. So far in FY21, RBI has purchased ₹3 trillion bonds, either by auction or by purchase on the secondary market. In doing so, it absorbed a quarter of the government’s borrowing program ₹12.8 trillion.
But unlike in the past, the borrowing itself is huge for this fiscal year and for the next fiscal year as well. Ergo, it is futile for RBI to remain a big buyer of bonds for long, especially when it has started to normalize liquidity. Other indirect signals of returns through bid breaks and trade twists are effective, but only for a short time. The chances of higher bond yields from now are mounting. Indian banks are gearing up to lend more to the private sector and credit growth is expected to pick up. They will have less incentive to keep buying government bonds. The outlook for retail inflation looks bleak with core inflation persisting and fuel prices rising. Additionally, bond yields globally are increasing and Indian papers cannot be an outlier. Then there is the offer of state government bonds. States have already borrowed nearly ₹6 trillion in the market and could end up borrowing another ₹1.59 trillion.
RBI will face higher bond yields or risk delving deeper into yield management. Central bank interventions are major market distortions and a risk to financial stability. As the guardian of financial stability, RBI will need to reduce its footprint in the market. As a government banker, he would just have to ask the Center to raise the price.
Granted, some analysts believe the central bank shouldn’t ditch bond yields. Soumya Kanti Ghosh, head of research at the State Bank of India, said the RBI should increase its bond purchases and do more interventions in the secondary market. In a note, Ghosh argued that rising yields would hurt banks as well as corporate borrowers. That said, the jury is still out on the benefits of RBI’s consistent interventions. As such, large central bank bond purchases in advanced economies have created problems even in emerging economies. The temptation to tighten its hold on bonds is strong for RBI, but it must be aware of the price distortions it creates in the market.