Benchmark 10-year yields, indeed the entire medium- and long-tenor segments of the yield curve, shifted up 10-odd basis points, a very sharp increase, reflecting the bearish sentiments in bond markets. This did not happen immediately after the monetary policy review statement, but a couple of days later when the RBI governor highlighted the prospects of continuing high fiscal deficits and the attendant market borrowing programmes.
Are these sentiments justified? Will the prospective borrowing and the potential supply of government securities in FY11 swamp the incremental demand for bonds, arising both from regulatory requirements and opportunities for earning some returns from bonds commensurate with investor risks? How much are inflationary expectations and prospects of monetary policy tightening influencing the current bearish view? An understanding of the dynamics of bond markets has widespread implications for borrowers across the spectrum, from short-term corporate borrowings to fixed deposits and from home loans to long-term infrastructure bonds.
Given the recently released revised numbers for India?s GDP, it is likely that the FY11 fiscal deficit will be in the range of 5.4-5.6% of GDP. This will entail market borrowings of the Centre at around Rs 3,60,000 crore. With a successful 3G auction and divestments of public sector entities, this might reduce somewhat. State governments might add around Rs 1,50,000 crore.
On the demand side, banks are required to invest 25% of their deposit and borrowed funds liabilities in government securities. Insurance and provident funds are required to invest almost half of their investible corpuses in government securities. Assuming a 14% nominal GDP growth, and financial savings of around 25% of GDP, of which about half goes into banks, the total demand from these entities is likely to be around Rs 3,70,000 crore. There might be some demand from foreign investors seeking interest differential arbitrages, adding around Rs 10,000 crore. These crude projections obviously imply a demand deficit, with the potential to push up yields.
No investor is likely to build up large exposures in bonds at this juncture, when interest rates across the spectrum are expected to harden, due to worries about taking mark-to-market losses on bond prices; they are likely to stick to the minimum regulatory requirements. In addition, there will also be a mismatch in the tenor strategy of the issuers (government) and borrowers. While the government is likely to issue longer- tenor securities to space out redemptions in the future, borrowers will try to bring down their portfolio maturities to reduce their exposure to tenor risk, aggravating the demand-supply mismatch.
Pressures at the shorter end of the yield curve will also begin to increase as bank credit offtake begins to pick up and the increased CRR takes out Rs 36,000 crore over February.
There are risks to this scenario as well. In terms of additional supply, there might, depending on how petroleum prices are treated, be another Rs 30-40 thousand crore of oil bonds. If foreign fund flows increase steadily, necessitating capital account management and currency interventions, additional liquidity sequestration will also increase MSS type securities. On the upside, higher growth will increase tax revenues, limiting the fiscal deficit and will drive up financial savings, which will increase institutional demand for bonds, both reducing the demand-supply gap.
In addition to supply imbalances, the spectre of inflation still looms large over the bond markets. Food prices and inflation have remained high, despite hopes that good rabi prospects might start bringing prices down. Globally, prospects of commodities prices inflation, following an evolving growth recovery, will keep headline inflation expectations high. In India, at least a part of the previously low administered prices will also be gradually oriented towards markets, taking inflation higher. Bond investors demand higher returns, adjusting for the erosion in the real coupon payments with higher inflation.
Global signals are not helping either. High fiscal deficits in developed countries, indications of policy tightening in some emerging markets and more sharply pronounced risk of sovereign defaults continue to keep the pot simmering.
Is there hope of bond yields softening in FY11? Looks unlikely at the moment. Fiscal pressures will continue. Policy rates have been reduced to virtually unprecedented low levels following the financial crisis, coupled with massive infusions of liquidity. Both will reverse course over 2010. This might, however, provide some slack in inflation pressures by compressing the speculative component in commodity prices, acting as a moderate brake on inflation expectations.
?The author is vice-president, business & economic research, Axis Bank. These are his personal views