Post-Brexit, the US 10-year G-Sec yield is at a 96-year low. Perhaps after a long hiatus, in India also there has been a concomitant decline in bond market yields, with the 10-year G-Sec yield and call money rates declining by around 35bps and 15bps, respectively. We believe this decline will continue for a while as markets across the world are flush with liquidity.
There are a couple of aspects to this decline. First, the decline in yields could have been even more, had RBI not narrowed the policy corridor from 100bps to 50bps recently. By doing so, it has effectively resulted in a floor under which call rates cannot fall, i.e. 6%. However, it must also be said that the use of liquidity as an active tool for optimising transmission impact by RBI since the last policy is paying rich dividends—core liquidity surplus at R70 billion right now, as against a deficit of R897 billion in April—in terms of lower money market rates and also in maximising the transmission impact (most banks have pared their MCLR recently). In this context, it cannot be overemphasised that the earlier preference to keep the system in deficit mode has only been effective when a tightening was attempted.
Second, notwithstanding the bravado by market experts and protagonists that everything will fall apart since the exit of the RBI Governor and the Brexit, India has actually witnessed a 32% increase in FPI inflows post-Brexit. This shows the resilience of Indian markets even in the face of adversities.
Third, the current yield differential between US 10-year G-Sec and India’s is higher than what it was one year ago (582bps against 505bps a year ago). It may be noted that prior to 2008, when India witnessed a surge in capital flows, the yield differential was around 300bps on an average. Hence, there are enough opportunities for Indian yields to move down even from the current levels (7.13%). This can be made possible through a re-look at the 100bps corridor between repo and reverse repo or through some other policy measure. The alternative is to cut the repo rate to enable yields to move down further. Will RBI take such a bet?
The same situation was prevailing during early 2007; when the liquidity was in excess mode, RBI had put a daily limit on reverse repo absorptions to a maximum of R3,000 crore each day, comprising R2,000 crore in the first LAF (liquidity adjustment facility) and R1,000 crore in the second LAF. This had resulted in call money rates crashing and 10-year yields declining then. However, this move was criticised at that time and was withdrawn. The central bank may think of alternate policy measures to help call rates move down further, in case it is averse to widening the corridor.
Our optimism regarding the 10-year yields declining further is strengthened by the fact that if the economy perpetually operates in a liquidity absorption mode, the LAF window would automatically become a window for banks to park surplus funds, and the variable reverse repo rate de facto becomes the fixed repo rate. Given that the historical differential between repo and 10-year rates has been around 50-65bps, there is every reason to believe that yields may even go closer or below the psychological barrier of 7%. Though it is difficult, but if that happens, RBI will clearly be able to effect a lower-term structure of interest rates in the immediate future.
Fourth, in August RBI will transfer the dividend to government and this will subsequently lead to further easing of liquidity in the market. Past data suggests that money market rates decline post such transfer in August.
To sum up, the decline in yields is also necessary, given that currently banks are in the midst of asset quality review (AQR) and need significant provisioning for such. From FY98 till FY2004, when banks were going through a similar predicament, the 10-year yield had crashed by over 800 percentage points (from 13% to 4.9%). As the accompanying graph shows, treasury profit to provisioning stood at 62% in FY04. This ratio had increased in FY15 to 17.4% from a low of 3.3% in FY12, but since then has declined to 14.8% in FY16. This reflects that 10-year yields had remained sticky in the past and hence the recent decline is all the more necessary for banks to help create a provisioning buffer in the midst of balance sheet cleaning.
(Sumit Jain and Tapas Parida, economists, contributed to the article)
The author is chief economic advisor, SBI. Views are personal