We live in interesting times. The GDP numbers confirm that Indian economy was perhaps in a slowdown mode from the second quarter of FY17. Simultaneously, the inflation numbers have positively surprised on the downside and are expected to stay significantly benign. Meanwhile, the banking system continues to be flush with liquidity post-demonetisation, further accentuated by a decline in credit offtake.
There has been abundant liquidity within the banking system coupled with relentless capital inflows since February. Our estimates suggest that even as Rs 2.6 lakh crore of incremental deposits net of credit is sloshing around, an estimated Rs 1 lakh crore or even more has flown into the financial markets through the FII route since February 2017. A mop up of such liquidity by Reserve Bank of India could inject further liquidity into the system. No wonder, RBI has resorted to buying and selling swaps in the forex market to neutralise the liquidity injection in lieu of purchase of dollars.
A significant chunk of such funds are being placed by banks with central bank, through its fixed rate and variable rate reverse repos, even though it now seems that such funds might stay with the banking system for a longer duration as credit growth continues to remain in low single digits. RBI has been conscious of such liquidity injection and has also been neutralising the impact of such forex inflows on the monetary base through Cash Management Bills (CMB) under market stabilisation fund (MSF).
Even as liquidity continues to be in abundance, that is commensurately not been reflected in the borrowing costs of the government. The 10-year yield was around 6.8% before demonetisation, and is currently around 6.62%, despite the additional Rs 3.6 lakh crore of liquidity in the banking system. Given that this year the central government is scheduled to borrow Rs 5.82 lakh crore, the higher yields imply a significantly higher interest cost for the government. We estimate that at the current yield of 6.6%, government borrowing cost could jump by an additional Rs 10,000 crore even on the most conservative basis. If we include the additional cost for state governments, this cost could go even higher.
Change in G-Secs (bps):
Yields in the Indian G-secs market have declined, as in most other countries. However, the level of yield decline is much lower than developed and even BRICS nations. During the period, China’s yield has hardened, the country’s rating has deteriorated.
Another way in which we can analyse the increase in costs for the government is through modified duration. As per CCIL data, the weighted average modified duration of the outstanding G-Sec portfolio of Rs 46.58 lakh crore was 6.22. Of course for new issuances, the duration would be higher. Additionally, RBI and the government have been trying to increase the average maturity of G-Secs. So, we can safely assume the modified duration for new issuances in FY18 to be 7. Ignoring the effects of convexity for simplicity, this means, for each 25 bps increase in the government’s borrowing cost, interest expense for the government goes up by a little over Rs 10,000 crore. Over a decade, this means an additional expense of Rs 1 lakh crore for each 25 bps increase in borrowing cost.
One major beneficiary of higher government borrowing rates have been FPIs, who have significantly increased their purchases after RBI MPC’s surprise decision to change its stance from “accommodative” to “neutral”. On February 8, 2017, total FPI investments in g-secs were Rs 1.1 lakh crore. This when 10-year yield was hovering around 6.4%. By end of May 2017, 10-year yield had increased to 6.62%, and FPIs, looking for higher yields, had increased their outstanding to Rs 1.54 lakh crore, an increase of nearly Rs 45,000 crore, with an additional Rs 30,000 crore limit still available for investment.
Interestingly, there is substantial economic literature on sterilisation of capital inflows and impact on domestic interest rates. It has been found that in east-Asian countries such sterilisation has kept interest rates artificially high, thus prolonging capital inflows. In essence, sterilisation of capital flows in east-Asian countries has not been successful in keeping domestic interest rates under check. If we juxtapose this experience in the Indian context, we find that sterilisation has kept interest rates high. While this may be leading to an appreciation of exchange rates and thereby minimising the impact of pass through, there is a downside too, a higher borrowing cost on the part of the government.