Hitendra Dave has tracked the bond and currency markets for more than a decade now. The Head of Global Markets, HSBC, tells Shobhana Subramanian that bond yields are headed up and could sustain at 8.55% if inflation does not come off meaningfully. Dave cautions that there should be adequate liquidity in the system, given the large supply of paper expected in 2011-12, so that the bond markets don?t become a source of problems.
Bond yields have increased sharply over the past few sessions?.
It?s difficult to say where yields will settle before the RBI policy meeting on January 25, 2011. But directionally, I think there is widespread consensus that bond yields can only go one way, which is up. That?s partly on account of the expected RBI?s policies but more so because by the end of February we will be looking at the budget and a borrowing programme as large as this year?s which at a gross level was around Rs 4.5 lakh crore. This year we had substantial maturities but next year the maturities are smaller and the base of GDP has expanded 4.8% so on a larger base would be a larger number. Also we will enter the new year with the banking system having a surplus SLR of somewhere between 2.5 lakh crore to 3 lakh crore. So there is no statutory need for banks to buy.
So all this could lead to bond yields stabilising somewhere at around 8.5% and I wouldn?t rule out 9%. I would say 8.5% on the ten year benchmark, could be the bottom of the range for the next financial year.
We?ve seen high yields before?..
In 2008 our yields were at 9%, on the back of tight policy rates and tightness of liquidity. But at that time we didn?t have this kind of supply of government paper. So while liquidity conditions may be better today than they were in late 2008 but that has been countered by the size of borrowings this time, three times bigger than it was then. What could keep bonds yields artificially low are measures to inject liquidity like bond buybacks, because that could create distortions. But I am assuming that will be resorted to only as a last measure. So on bonds we have a negative view.
So what is the yield curve going to look like?
Given a scenario in which policy rates are headed higher because inflation has been stubbornly sticky, and in which no expects inflation to come off meaningfully, it is imperative that policy makers don?t cause a problem by keeping liquidity so tight that bond markets themselves become a source of another problem. If you keep liquidity tight at a time when borrowings are going to increase there will be problems. On the liquidity side, conscious efforts will be made to ensure that the system is surplus which, we believe, would happen anyway because the government has to spend close to Rs 4 lakh crore and also because of the impact of Rs 48,000 crore of bond buybacks. Moreover, there should also be an increase in deposits. Because the liquidity conditions have to be normalised, for the borrowing programme to go through smoothly, you could have short-end yields, say for CPs or CDs, remaining at or lower than current levels. In other words, we could have a fairly steep yield curve.
How do you think the RBI will keep liquidity surplus when inflation is raging?
The key is what instruments they use to ensure that liquidity conditions are normal or in a slight surplus mode. There is a communication challenge here. If you do bond buybacks, it doesn?t require any significant communication but it creates its own problems because it distorts the long-end of the yield curve and the bond market also becomes illiquid.
Where do you see the rupee headed?
So far this year, capital flows have been lower than what people expected after QEII. The challenge is that after a long time, we are starting a year with a macro situation that is not as good as it used to be because of the twin deficits, inflation and a relatively expensive stock markets. We are priced for very few mistakes. It?s too soon to tell whether investors will hold back money but if policy makers take decisive action money will flow in. We believe the rupee will stay in a band of 3-5% of the current levels either way.