I used to think if there was reincarnation, I wanted to come back as the President or the Pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody,” said James Carville, an adviser in the Bill Clinton administration in 1993, when bond yields in the US spiked in response to fears of increased spending.
The quote, now a favourite of bond vigilantes, took on an Indian connotation last week when the Reserve Bank of India’s (RBI) governor Raghuram Rajan used it in a speech in New Delhi. Rajan was sending a message, perhaps on behalf of the bond markets, to the government. The message: we won’t take kindly to stretching the fiscal deficit targets for a second year and we are not comfortable with the surge in supply of state government bonds.
The message from the bond markets, if not intimidating, is certainly worrying. And the message is going out both to the Narendra Modi-led central government and the Rajan-led central bank.
As always, the bond market is talking through yields:
•The yield on the 10-year benchmark bond is now at about 7.84%, similar to the level in January 2015, when the RBI started cutting rates.
•The 3-month commercial paper yield, a benchmark for short-term corporate borrowing, is at 9%, which is higher than a year ago.
•The yield on state development loans in the most recent auction in January was between 8.36% and 8.42%. A year ago, it was in the range of 8.05-8.10%.
There are multiple messages in these bond yields. Let’s start with what the markets are trying to say to the government.
Last year, while presenting the Union budget, the government decided to give itself some wiggle room on the fiscal deficit. It said it would take an additional year to get to the medium-term fiscal deficit target of 3%. The roadmap laid down mandated a 3.9% fiscal deficit for the current fiscal and 3.5% for fiscal 2017.
Now there are murmurs about a further dilution in the fiscal consolidation roadmap, despite the fortuitous event of low oil prices. Bond markets were forgiving of the relaxed targets last year, but not so this year. This time they want the government to stick to its plan.
The second part of the message to the government is around the finances and borrowings of state governments.
In particular, the bond markets are extremely uncomfortable with the supply of state bonds that will come in when the Ujwal Discom Assurance Yojana, or UDAY scheme, is implemented. The scheme will see 75% of power distribution company (discom) debt being converted into state government bonds. These bonds will add almostRs.3 lakh crore to the stock of state bonds. What is not clear is whether these bonds will sit on bank books or come into the market. Either way, there will be damage. If they sit on bank books, the appetite of banks to participate in state bond auctions will reduce. If they come into the market, supply will far exceed demand, and yields will jump.
According to some market participants, the government has sounded out mutual funds and insurance companies to find a pool of capital to invest in these bonds. How and where will they find this capital? No one has the answer.
Markets are asking the government for clarity and sending the message that the discom revival plan will come at a cost.
In a conference call with analysts after Tuesday’s monetary policy review, RBI deputy governor H.R. Khan acknowledged that state borrowings are a problem. “State government loans have ballooned,” said Khan, who is not someone pre-disposed to making dramatic statements.
The RBI, however, cannot lob the ball entirely in the government’s court.
The bond markets have something to say to the central bank too. Here, the message from the markets is that the liquidity framework under which the RBI is operating is not working.
Liquidity conditions have been tight and while the RBI has chipped in with the odd OMO (open market operation), it has stayed with its stance of maintaining liquidity in deficit even though its current monetary policy stance is “accommodative.”
Under the current framework, the RBI has reason for this. Remember that we still have two different policy rates—the repo rate and the reverse repo rate (which is 100 basis points, or 1 percentage point, lower than the repo rate). The repo rate is seen as the operative rate when liquidity is in deficit, but in times of surplus liquidity, the market tends to take the reverse repo rate as the benchmark. So, if the RBI allowed liquidity to be consistently in surplus, the operative rate would move 100 basis points lower than the current policy rate (which is the repo rate) of 6.75%.
Clearly, the central bank won’t want that as the level of repo rate is what it is comfortable with against the backdrop of prevailing inflationary conditions.
While the RBI has a point, so does the market. The market’s view is that maintaining a liquidity deficit is impeding transmission of lower rates and preventing yields from falling.
In the post-policy conference call, governor Rajan seemed to acknowledge that the liquidity framework needs adjustment. “We are looking at the liquidity framework over the next few months… we will keep you appraised of developments,” he said.
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