Twisting the curve

Investors have noted the steepening of the yield curve for Indian government debt with concern. In recent weeks, the difference between yields on the 10-year government paper (government securities or G-Secs) and the two-year variant has widened the most in nine years, since the high-spending days of the post-financial crisis fiscal stimulus. This is a result, in all likelihood, of worries that in spite of there being practically no fiscal space, the government will feel itself forced to stimulate the economy through some spending or tax measures as a response to stalling gross domestic product (GDP) growth. A difficulty in meeting the fiscal deficit target of 3.3 per cent of GDP means that there is a disconnection between long- and shorter-term expectations of growth and inflation, resulting in a steepened yield curve. Market participants expect enhanced borrowing from the government, weighing down the long-term expectations of yields as ample liquidity at the shorter end has underpinned the market for the corresponding bonds. The Reserve Bank of India (RBI) held rates steady at the meeting of the monetary policy committee earlier this month, while financial markets were expecting another rate cut.


The central bank has now responded to some calls from market participants by announcing that it will conduct an unusual set of open market operations — buying Rs 10,000 crore worth of 10-year G-Secs and selling a corresponding amount of bonds due to mature on a shorter timeframe. This is being seen as an Indian variant of the United States Federal Reserve’s “Operation Twist” early in this decade, which was meant to spur lending by banks. The RBI’s concern, reportedly, is that the transmission of its previous rate cuts — by 135 basis points over the course of 2019, in five different cuts — is faulty. This is in keeping with the bank’s consistent claims that it manages liquidity and not yields. Heavy government borrowing has put upward pressure on interest rates, which have rendered the transmission of the rate cuts difficult.


Yet it is far from clear that the RBI’s goal will be achieved. Certainly, there might be some flattening of the yield curve. But it is not clear that the amounts being discussed are sufficient. The response of the market for short-term bonds is also being questioned. The sale of the shorter-tenor bonds might well blow up yields in that segment, according to some market participants; on the other hand, liquidity at that end is so ample that there might be an effective cap on yields. The essential problem in the Indian bond market is that the country has, in spite of an apparently manageable debt-to-GDP ratio, entered a state of effective fiscal dominance. Heavy government borrowing has rendered monetary policy increasingly ineffective. Measures to address the yield curve might provide some temporary relief. But the broader issue is the long-term uncertainty on the path of inflation, rates, and deficits caused by ballooning government commitments. While the RBI can and must do its part, the primary responsibility for addressing this uncertainty belongs to the government. As the Union finance ministry continues its pre-Budget consultations, it must recognise that fiscal prudence and transparency are non-negotiable.


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