The Narendra Modi government announced a higher-than-expected market borrowing of Rs 12 lakh crore for 2021-22. For this fiscal too, the government said it would borrow an additional Rs 80,000 crore from the market.
The bond market seems to be uneasy with the additional market borrowings and the gradual glide path of fiscal consolidation announced by the government.
While bond investors are demanding higher yields, the Reserve Bank of India (RBI) as the debt manager to the government has been under pressure to step in to keep yields in check.
Conflict over RBI role
This conflict between RBI’s mandate to target inflation while serving as the government’s debt manager is going to sharpen over the next couple of years.
With a larger borrowing programme there will be a pressure on interest rates to rise. As debt manager, the RBI has to keep the government’s cost of borrowing low. But if inflation starts rising, it has to raise interest rates to prevent price rise. Already, the situation is turning difficult as there is upward pressure on interest rates from the market.
As long as inflation is low, the RBI will step in and purchase bonds, when interest rates start rising, thereby pushing up liquidity in the system and pushing down rates.
The tug of war between bond buyers and the RBI has been playing out for most part of this year. The central bank has resorted to a series of policy measures, particularly open market operations (OMOs) and operation twists, to manage the yields.
OMOs typically involve buying or selling of bonds to manage liquidity. When there is an upward pressure on yields, RBI buys bonds, which injects puts fresh money or liquidity into the market. More liquidity helps in bringing down interest rates. The RBI has already conducted Rs 3 lakh crore of bond purchases under OMOs this year.
Despite these measures, over the last few weeks, the demand for bonds has been tepid. The RBI has refused to sell bonds at the yield demanded by bond investors. As a result, it has been forcing underwriters to buy bonds. Amid a series of development on primary dealers, the RBI has offered higher underwriting commissions to facilitate buying by primary dealers.
While the central bank has assured that it will do whatever it takes to ensure that the borrowing programme goes through smoothly, the market doesn’t seem to be convinced.
Firstly, the government has announced that it will target a fiscal deficit of 4.5 per cent over the next five years. This implies that the borrowings from the market will remain elevated in the next few years, thus pushing the yields up. Not only the central government’s, but state government borrowings have also risen and will likely rise further as states have been allowed additional borrowings from the market.
Secondly, while the RBI has reiterated in its forward guidance that it will maintain an accommodative stance to revive growth, certain announcements by the central bank were perceived to be a signal towards reversal of the accommodative stance. It also undertook a slew of measures to infuse liquidity into the system such as long-term repo operations and targeted long-term repo operations.
To ensure liquidity with banks, the RBI had announced a 100 basis points cut in cash reserve ratio (CRR) in March 2020 for a period of one year. In its latest Statement on Developmental and Regulatory Policies, it announced a phased restoration of CRR to 4 per cent from 27 March. This was seen as a move towards reversal of accommodative stance by the RBI.
Thirdly, the RBI’s strategy of pursuing multiple objectives such as exchange rate management, inflation control and liquidity management has led to distortions and confused the market. It has been intervening in the market to prevent the rupee from appreciation amid a surge in inflow of foreign investments.
The buying of dollars has increased the supply of rupee liquidity. Thus, while the short term rates — the weighted average call rates and the t-bill rates are low (even below the reverse repo rate) — the yield on long-term bonds have risen on concerns over higher government borrowings.
As an outcome, the spread of 10-year government bond over the repo rate has remained widened. Other measures of term premium — the spread of 10-year bonds over 1 year t-bills — has also widened. The widening of the term reflects doubts over RBI’s actions to manage the government borrowing programme.
India needs debt management office
Finally, as inflation concerns resurface and demand revival gains momentum, the trade-off between inflation management and debt management could become sharper.
Rise in global crude oil prices and commodity prices could translate into higher input costs and thus higher broad-based inflation.
While the RBI has placed greater priority on reviving growth, it would have to change its accommodative stance and move towards interest rate hikes. This could complicate the debt management function of RBI. The time is perhaps apt to bring back the agenda of an independent debt management office to address some of these concerns.
Ila Patnaik is an economist and a professor at National Institute of Public Finance and Policy.
Radhika Pandey is a consultant at NIPFP.
Views are personal.