Published on 13/03/2019 11:43:49 AM | Source: HT Media

Opinion | The confusing message from the India bond market

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The bond market had rallied soon after the Reserve Bank of India (RBI) announced a surprise rate cut on 7 February. The overwhelming consensus in the days preceding the policy announcement was that the Monetary Policy Committee (MPC) would shift its stance back to neutral but would not actually bring down the repo rate.

The consensus is now shifting. There have been growing expectations since then that the Indian central bank will cut rates once again when its Monetary Policy Committee meets in April. However, the bond market is not reflecting these more dovish times. The yields on 10-year government bonds have barely budged once the brief rally dissipated a few days after the February rate cut. A few bankers I spoke to even argue that lending rates will go up in the coming months even if RBI brings down policy rates.

There are three possible ways to explain this paradox. First, the difference between short-term and long-term borrowing costs has perhaps widened because bond traders are expecting inflation to bounce back from its current lows, and interest rates to follow. The bond market is less confident about low inflation than RBI is. A steeper yield curve is odd at a time when even household inflation expectations have been coming down while the Indian economy is in the midst of a cyclical slowdown.

Second, there are more practical worries about the pressure on the stock of available household financial savings. The worries here are evident. The government has to raise a record sum through bond sales to fund its deficit for the next fiscal year. The demand for private sector bank credit is also picking up after a long hiatus. Bank credit growth has of late been increasing more rapidly than bank deposit growth. Such borrowing pressures are keeping bond yields higher than expected.

Third, there is little clarity about what the central bank will do in such circumstances. A recent survey of traders and economists by Bloomberg showed that they expect RBI to buy only ₹1.7 trillion of bonds in 2019-20, as compared to the ₹3 trillion it bought in FY19. The possible reduction in open market operations by RBI is sending a current of uncertainty through dealing rooms.

Should RBI explicitly signal its broad market intervention strategy to reduce such uncertainty? Or would it be pandering to the bond market by doing so? One way to look at the challenge is through the lens of quantities versus prices.

Central banks usually use three sets of policy tools to intervene in an economy. First, they adjust quantities such as the supply of broad money. Second, they tinker with prices such as interest rates. Third, they use direct controls to manage bank lending. The third has been used only very sparingly in recent years.

The Indian central bank was one among dozens of central banks that primarily depended on adjusting quantities such as money supply during the high noon of monetarism across the world. Managing money supply growth was the main monetary policy tool. That gave way to the use of prices, or interest rates, to do the job after monetarist practice crumbled because demand for money became unstable in the wake of financial liberalization in the 1990s. Tweaking the short-term interest rate is now the name of the monetary policy game.

Yet, quantities cannot be wished away when it comes to the operation of monetary policy. A central bank has to manage its balance sheet to ensure that there is enough durable liquidity to ensure that money market rates are aligned with policy rates. Many central banks give forward guidance to the markets on the course of interest rates. Should they be doing so when it comes to durable liquidity?

C. Rangarajan and Amaresh Samantaraya highlighted some of these issues in a June 2017 paper published in Economic And Political Weekly. They pointed out that in its annual report published in 2015, RBI said that “the link from policy rate to inflation target requires a systemic and stable transmission path linking the policy rate, the operating target, an intermediate target and a transparent set of rules guiding liquidity and monetary operations on a day-to-day basis" (emphasis added). The monetary policy statement of April 2016 also had a long discussion about the need to manage durable liquidity so that RBI can meet its main policy goals. There has also been ample discussion about whether the policy goals of the Indian central bank are better met when the money market operates under conditions of a liquidity deficit or not.

None of these are easy issues to tackle, especially in a bond market dominated by the fiscal needs of the government as well as the harsh fact that large segments of the bond market are illiquid. The Urjit Patel Committee report went at great length to analyse the operating framework for Indian monetary policy. Recent events—from the tight liquidity in the last few weeks of 2018 to the more recent stickiness of bond yields despite expectations of monetary policy easing—suggest that the Indian central bank needs to signal its durable liquidity intentions more effectively.

Niranjan Rajadhyaksha is research director and senior fellow at IDFC Institute. Read Niranjan’s previous Mint columns at