Column: Why are GSec yields high

Updated: Mar 6 2014, 08:17am hrs
Markets, as a rule, are filled with noise which keeps analysts in business. Normally, we tend to say that the stock markets are whimsical and cannot be predicted. Otherwise one cannot explain how the Sensex has shown remarkable buoyancy during the year notwithstanding the relentless flow of negative news. The bond market also has assumed a rather unpredictable course with reasons being often ascribed post facto while conventional tools for analysis have not been able to deliver tenable a priori explanations.

The GSec market is probably one of the few active ones on the debt side and the 10-year paper is taken to be a proxy here. Typically, the yield should be reflective of liquidity conditions. The 10-year yield has been in the region of 8.8%, and while it was expected to come down with the rupee stabilising and liquidity conditions improving, things have not quite turned out that way. Last year at this time, the yield was around 7.8%, i.e., 100 bps lower.

Liquidity conditions prima facie look stable presently. Growth in deposits has been higher than that of bank investments and credit in incremental terms. The inflow of deposits through the

FCNR route has made this possible. In fact, this was not the case last year, where supply of funds through deposits was lower than the outflow through credit and investments thus necessitating affirmative action from RBI through the repo window. This time round, RBI continues to support through the repo, term repo and MSF routes. In fact, the overall outstanding amount through these combined routes would be about R70,000 crore, almost the same amount supplied last year directly through the repo window. This time round, RBI has channelled more funds through the term repo window which is understandable, given that the recommendations in the Urjit Patel Committee report, which speaks of the migration to the term repo as the signalling tool, are likely to be adopted.

Based on relatively stable liquidity conditions, compared to last year's, the GSec yields should have been moving downwards. The exchange rate too has been stable, unlike it was in the period May-September 2013 when high levels of volatility had prompted the market to panic. Also inflation has been coming down, which normally should have gotten buffered in the downward direction of interest rates. Last, despite all the pessimism expressed on the fiscal front, the government has stuck to the fiscal deficit target (in fact, it has been bettered) and the government has ended up borrowing less than what was targeted. Even while the fiscal deficit for the first 10 months has come in higher than 100% of the target, the tax collections in March along with the spectrum sales flows would help to bring down the deficit. Therefore, this also should not really be a concern.

Why then are the yields sticky in the upward direction A clue can be had from the profile of the entire spectrum of rates where the short-term yields have, at times, been higher than the long-term ones. This, theoretically, is reflective of a recession. But given that the GSec market is not really reflective of what happens in the corporate debt marketwhich is not active anywayit may not hold even though there is a slowdown in the economy. But, the CP rates have also been high with the one year rate being above 10%. This situation of short-terms rates being higher provides an answer here.

First, RBI has indicated in its last policy that it would continue to target CPI inflation. While CPI inflation has started moving down, the fact that RBI has spoken of 8% target for January 2015 gives the impression that RBI does not expect the current downward movement to continue for long. Therefore, the market is not expecting RBI to lower interest rates any time soon, which has put pressure on yields. Second, global uncertainty still remains. While the Fed tapering has begun, which has not quite had a very perverse effect on inflows so far, the market is still waiting and watching whether there will be outflows once the tapering size become cumulatively larger, i.e., say, in five months, the funds will be shrunk by $50 billion.

Third, the market is presently also following the normal end-of-the-year pattern where the month of March sees tax outflows: advance tax of corporates, excise and service tax flows. This would put pressure on the banks as there are withdrawals by corporates. In fact, the banks would also be typically upping their bulk deposit rates for short tenures to meet this contingency. Simultaneously, there would also be pressure on banks on account of mutual funds, where there tends to be higher amount of redemption for meeting year-end targets. This is one reason for banks to also access the term repo window regularly.

Last, the spectrum sale would mean that companies would have to pay at least a third of the amount this financial year. While part of this could be met from internals, the rest would come from loans by banks. This would also put pressure on bank liquidity as credit increases. One can hence expect rates to inch upwards till the end of March, and come down only when the money flows back into the system.

Therefore, the movement in GSec yields can, in a way, be said to be forward-looking where expectations of the future state of liquidity would get absorbed in the yield rates in advance, which is what we are witnessing today. A lot will depend next on what RBI has to say in April as it will also guide investment decisions. RBI may prefer to wait and watch on inflationary developments and expectations as well as the Budget to be announced once the new government is in place.

Madan Sabnavis

The author is chief economist, CARE Ratings. Views are personal