Managing suppressed G-Sec yields

April 19, 2021 4:30 AM

RBI must juggle its multiple hats well to manage positive and negative pay-offs dexterously

This is a good time for RBI to relook at banks’ internal mechanisms to avoid the temptation of mispricing risk in easy liquidity scenario.This is a good time for RBI to relook at banks’ internal mechanisms to avoid the temptation of mispricing risk in easy liquidity scenario.

By Ashish Kapur

The G-Sec benchmark rates, to which other lending rates are intricately linked, should ideally be a reflection of real market rates—so as to encourage constructive channelisation of financial savings towards investment needs of the economy. While setting low G-Sec yields is the prerogative of the Reserve Bank of India (RBI), with the obvious cooling government borrowing costs coming as a big pay-off, it has negative consequences, too, which is becoming increasingly disconcerting.

First of all, benchmark rates suppressed with a view to finance deficits cheaply drive down the related interest rates in the economy. The resultant lower bank deposit rates and muted small savings coupons thus become a negative pay-off. The recent announcement and prompt withdrawal of small savings rate cut by 50-110 bps for June 2021 quarter comes as a breather to the end-savers constituency, largely comprising of senior citizens and pensioners, after the shock of about 1% average cuts last year.

To finance government borrowings efficiently, RBI has ensured that G-Sec yields are subdued by playing out quantitative easing instruments at its disposal, like the Operation Twist—large liquidity infusions that keep yields artificially low by selling near-term treasuries to buy longer-dated ones, thereby driving down long-term interest rates—helping borrowers no doubt, but breaking the back of end-savers who earn lower interest income, further eaten away by rising inflation, since ultimately small savings rates are linked to G-Secs.

Secondly, with RBI infusing liquidity via the Operation Twist and recent open market operations like the G-Sec Acquisition Programme (G-SAP) to reduce yields, bond prices that are inversely proportional to yields have consequently gone up. Forget equity markets, even the currency markets appear to be jittery!

As investors increasingly find rates being unattractive, bond yield differential tilts and increases the cost of owning the lower yielding currency. The rupee depreciation in April seems to be following this script and looks another unintended consequence of keeping government borrowing cost in check by suppressing G-Sec yields. With commodity prices heating up and frequent Middle East crude turbulences adding to the import bill and net inflationary effect, the rupee is likely to remain volatile in the short run and RBI may need to frequently intervene to ensure that strong overseas institutional inflows that have hitherto supported the rupee are not reversed.

The moot question is whether a 25-30 bps increase in the G-Sec benchmark yield over time can be so fiscally catastrophic, and how significant is the trade-off considering both money and currency markets? RBI using ammunition solely to cap bond yields may be the wrong battle to focus on as demand-supply dynamics would suggest letting benchmark rates glide upwards smoothly, much like its own currency market interventions.
The third trade-off to be evaluated is the declining domestic savings over the last decade, which impacts the investment rate unfavourably.

India’s gross domestic savings rate, which was 34.6% of GDP in FY12, fell to 30.1% in FY19 vis-à-vis around 45% in China. Household savings in financial/physical assets, which constitute roughly 60% of the gross savings, fell from 23.6% of GDP in FY12 to 18.2% in FY19. The savings level is unlikely to materially change in FY21 and FY22 as livelihoods get impacted due to loss of momentum, labour contribution contraction, restricted mobility and periodic lockdown/second-wave restrictions.

Theoretically, a falling savings rate leads to Indian entities accessing more capital overseas, thereby increasing external debt and current account deficits. True, record foreign inflows in later half of FY21 have been most welcome, but there is no certainty of the future. The importance of increasing savings rate in the long term to bolster investments cannot be overemphasised. To encourage savings, especially in financial assets, nominal returns on bank deposits and small savings should meaningfully compensate the end-savers.

Lastly, the impact of suppressed benchmark rates on mispricing risk by lenders and consequential bad loan problem can’t be ignored. Mispriced loans to certain sectors with larger ticket sizes besides laxity in assessing borrowers for state schemes coupled with bad/constrained lending practices worsen overall systemic risk. It is imperative to price credit right, basis the scarce investment capital available and real cost of capital, besides comprehensive analysis of sectoral nuances and counterparty risk.

With asset-heavy financial statements making it an ideal candidate, banking credit to industry stood at an impressive 40% level till about FY16. However, with the services’ contribution to the GDP becoming dominant, coupled with the reduction in cash/undocumented transactions fast-tracked in the digital GST era, credit disbursement to the services sector is progressively inching upwards, with a high upside potential.

Given the evolving sectoral contribution to India’s GDP, there is also a change in dynamics of non-food bank credit allocation across industry, retail, services and agriculture, which stood at 29%, 29%, 28% and 13%, respectively, in February 2021 as per recent RBI data analysis by QuantEco Research. This is a good time for RBI to relook at banks’ internal mechanisms to avoid the temptation of mispricing risk in easy liquidity scenario.

The possibilities

Now, what can the banking regulator do to manage the pay-offs well and effectively navigate its difficult role of being the government’s banker, whilst simultaneously ensuring that savers get a better deal on bank and small savings deposits?

For starters, letting benchmark yields inch up marginally over time can be considered seriously, which will have a trickle-down effect on the term deposit rates. With G-SAPs lowering longer-term yields, RBI can use the reverse repo route to increase short-term rates. While this may flatten the yield curve eventually, it would make a case for banks raising short-end deposit rates, too.

Changing the benchmark for small savings or delinking from G-Sec and tweaking the cost of deposit funding benchmarks to enable savers make worthwhile nominal returns net of inflation merits consideration. Finally, pricing risk right across infrastructure, manufacturing and services segments opens up that much more leeway for raising deposit rates for the end-savers.

The pandemic-induced challenges and the consequent government spending make it critical for RBI to continue juggling its multiple hats well to manage positive and negative pay-offs dexterously.

The author is a certified treasury manager and a veteran corporate banker

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