The behaviour of sovereign bond markets over the past couple of months has not only made life difficult for bond dealers in fixing any kind of trading strategy, but also neutralised the efforts of both RBI and the government to lower the yield curve. This will have an adverse effect on the cost of the massively increased government borrowing programme and simultaneously set a high benchmark for bank lending rates and corporate borrowing.
After falling to 5.24% in early January 2009 (and under 5% in intra day trade), the yield on the benchmark 10 year paper had shot up by almost 100 basis points in just two days to 6.35% and thereafter, has been wobbling around 6.20%. All indicators of volatility have spiked. This buffeting in bond yields is the stock market equivalent of about a sharp 30% change in the Sensex.
Why did this happen? There were ambiguities in announcements of increased government market borrowings, for a start. Markets and analysts had been expecting the need for larger borrowings after the September 2008 turbulence and collapse of exports, but the magnitude of the revised borrowings in early January (after the stimulus packages) surprised them. Then, after expecting a stable review of numbers in the interim Budget, they were surprised yet once again by the third stimulus package in end-February.
Then came the news, in the revised borrowing schedule, of issues of papers at maturities that were different from expectations, and which were relatively illiquid. There were a couple of sporadic instances of cancellations of scheduled Market Stabilisation Scheme (MSS) buybacks. There were a couple of unexpected decisions of underwriting commissions for Primary Dealers at around this time. Aggravating all of this was the switchover of the benchmark 10-year paper from the old 2018 to the new 2019 issue. Markets had earlier bought large quantities of the former paper, in anticipation of benefiting from valuations derived from expected drops in interest rates. When the 2019 paper came to the market, they consequently sought to sell, in an effort to maintain liquidity in their portfolios.
All this would have mattered little in normal times. But in this era of heightened uncertainty and volatility, the cumulative effects were magnified. The net result was a significant nullification of monetary policy transmission, where the continuing series of short-term policy rate cuts did not result in a corresponding fall in sovereign yields at longer maturities. This phenomenon of yield stickiness is not confined to just India.
What might be the most effective ways of alleviating this situation? The uncertainty over the governments? (both the centre and states) borrowing programme is likely to persist well into 2009. The current economic and political situation is too fluid to enable definitive projections of trends in 2009-10. Expectations of a persisting slowdown leading to depressed tax revenues and the probable need for further fiscal stimulus measures are feeding expectations of continued high fiscal deficits and large borrowing programmes. This is likely to keep sovereign yields relatively high.
To facilitate this large borrowing without an unwarrantedly large adverse impact on rates, the option before RBI is to resort to various ways of quantitative easing. This is very similar, although not in entirety, to what in a previous avatar, we had called ?monetisation?. Quantitative easing is essentially the RBI resorting to using the asset side of its balance sheet to manipulate the yield curve, at a time when the transmission channels of changes of the short-term policy rates have minimal effect.
The options before the RBI are to use Open Market Operations (OMOs), take on private placements directly from the government and ?desequester? its MSS holdings. Use of the latter is our own first preference. As of March 6, 2009, the RBI still had over Rs 88,000 crores in MSS holdings, on which it presumably pays 6-7% in interest, annually (remember, these were contracted during days when the coupon was still high). These are precious resources, and there is little justification for holding on to these. Of course, looking at past issues of MSS securities, a large part will be unwound within the next few months anyway. Also, the tenor of existing MSS securities might not match market requirements. This is where the other instruments come in. OMOs allow the RBI to selectively manipulate the yield curve at tenors where it feels that there might be large distortions, both due to demand supply mismatches. A constraining factor is the type of securities that the RBI currently holds. The other is placement of government securities directly with RBI. We are still awaiting clarity on the procedural clearances required to set aside the restrictions on this in the FRBM Act.
Any of these measures will result in monetisation. Will this be a prelude to creating a potentially hyper inflationary situation? Probably not, in the immediate future. The outcome will depend on the money multiplier, which translates the increased reserve money base into broad money and liquidity. Given that bank credit growth is an important component of this multiplier, the linkages into systemic liquidity might be expected to remain weak or moderate.
?The author is vice-president, business & economic research, Axis Bank. These are his personal views