BackWhy the bond yields will harden
Given market dynamics of supply outstripping demand, we may witness bear steepening of the yield curve
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Since the beginning of calendar year 2015, rapid disinflation owing to the fall in global crude and commodity prices has helped the Reserve Bank of India (RBI) continue its monetary accommodation with reduction in policy rates by 125 basis points (bps). One basis point is one-hundredth of a percentage point. Though RBI has substantially reduced the policy rate, yield on the 10-year benchmark government securities (G-Secs) is holding at near 7.8%. In fact, yield spread of state government securities over central G-Secs has widened from around 45 bps to 70 bps.
We believe such a trend is, in fact, justified based purely on market fundamentals with respect to demand-supply mismatch.
Consider the following. On the supply side, fiscal consolidation has ensured net dated supply at nearly the same level for the past five years (from ₹ 4.36 trillion in FY12 to ₹ 4.4 trillion in FY16). However, the state side story is not at all encouraging. Over the same period, this has almost doubled (from ₹ 1.45 trillion in FY12 to ₹ 2.78 trillion in FY16).
Supply side equation has been further complicated by the recent Uday scheme (Ujwal Discom Assurance Yojana) announcement by the government, aimed at the revival of debt-laden power distribution companies. As most of the states have agreed to its implementation, it indicates that a ₹ 2.1 trillion worth of bond supply will hit the investment book by the end of FY16. Interestingly, in the current fiscal, the supply pressure has intensified and increased 35% year-on-year, a trend that will continue in FY17.
On the demand side also, though the banking sector has remained the major buyer for government bonds, such demand is declining with lagging deposit growth. For example, banking sector aggregate deposit growth in percentage terms has come down from 25% in 2008 to around 10% in 2015. Additionally, banking sector statutory liquidity ratio (SLR) requirement has been steadily reduced over the years from 25% as on November 2009 to 21.5% as on February 2015.
Along with the reduction in SLR requirement, held to maturity (HTM) facility has also been aligned to SLR in phases. The combined effect of all these resulted in lower demand from the banking sector. As per the available data, in FY15 banking sector net purchase of G-Secs and state development loan (SDL), or state government bonds, was only ₹ 1.88 trillion, less than the seven year average of ₹ 2 trillion and significantly lower than ₹ 3.2 trillion in FY14. Going forward, this situation will only change significantly if deposit growth revives meaningfully. Also, there will be a further 100 bps reduction in SLR and HTM in FY17.
In FY15, lower demand from the banking sector was more than compensated by others. Foreign institutional investors (FIIs) alone purchased bonds of around ₹ 1 trillion in FY15. However, in a recent auction, the limit for SDL as well as that of long-term investors remained unutilized. Going forward, this situation will change only if global growth picks up. Besides FIIs, other members of the investing community such as mutual funds and corporate investors were also substantial in FY15.
As opposed to the seven-year average of only ₹ 10,000 crore, mutual funds purchased ₹ 45,000 crore on a net basis and corporate purchases were around ₹ 20,000 crore. Additionally, insurance companies in FY15 purchased bonds worth around ₹ 2.4 trillion at a net level ( ₹ 1.9 trillion in FY14). In FY15, pension and provident funds together purchased around ₹ 90,000 crore ( ₹ 45,000 crore in FY14).
Thus, given the market dynamics of supply far outstripping demand, we may witness bear steepening of the yield curve, with steepening in the medium (10-15-year duration segment) and upper end (above 15-year segment) of the curve due to excess supply of medium and long-term paper relative to demand.
In fact, we are in a similar predicament now as we were in FY09. In FY09, the government had issued oil and fertilizer bonds worth around ₹ 1 trillion. In essence, all this had resulted in additional government borrowing.
If we draw a similar analogy here, in order to fund gross domestic product growth of even around 6% (as per the old series), RBI needs to inject primary liquidity of around ₹ 2 trillion. In FY16, ₹ 33,000 crore has been added to net foreign assets. This clearly necessities injection of primary liquidity through purchase of domestic assets to make up for the shortfall (open market operation purchases by RBI were ₹ 5.31 trillion for the six-year period ended FY13).
An anecdote before we end. Countries such as China, Russia and Brazil currently have a downward sloping yield curve at the long end, even as these are ravaged by global gloom, among other factors. However, in the Indian context, we are in the exact opposite situation with the yield curve sloping upwards at the long end.
Better transmission of monetary policy impulses to the long end, perhaps through an accommodative liquidity injection/open market operations by RBI may do the trick for India, as was done in the past (FY12, for example).
Soumya Kanti Ghosh and Ramkamal Samanta are, respectively, chief economic adviser, SBI, and vice-president, SBI DFHI.
Comments are welcome at theirview@livemint.com
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