General Studies- III (Indian Economy)

EDITORIALS: In-Depth

08 May 2021

Recently, the Reserve Bank of India’s decision to step up purchase of government securities under the government securities acquisition programme (G-SAP) led to the yield on the benchmark 10-year bond falling below 6%.

What is G-SAP and how is it different from a regular bond purchase?

The RBI periodically purchase Government bonds from the market through Open Market Operations (OMOs).

• The G-SAP is in a way an OMO but there is an upfront commitment by the central bank to the markets that it will purchase bonds worth a specific amount.
• The idea is to give a comfort to the bond markets. In other words, G-SAP is an OMO with a ‘distinct character’.

Recent movements in bond yields:

Movements in yields, which depend on trends in interest rates, can result in capital gains or losses for investors.

• If an individual holds a bond carrying a yield of 6%, a rise in bond yields in the market will bring the price of the bond down.
• On the other hand, a drop in bond yield below 6% would benefit the investor as the price of the bond will rise, generating capital gains.
• “G-SAP has engendered a softening bias in G-sec yields which has continued”. RBI Governor said.

Why are bond yields softening?

The fall in bond yields in India could also be due to a sharp decline in US Treasury yields or the economic uncertainty caused by Covid-19.

• But the most important driver of the bond market was RBI interventions.
• The announcement of a bond-buying programme – G-SAP — at the start of the month played a crucial role in turning the market sentiment.
• The RBI continued to send strong yield signals by cancelling and devolving government debt auctions.

What’s the impact on markets and investors?

Experts say the structured purchase programme has calmed investors’ nerves and reduced the spread between the repo rate and the 10-year government bond yield.

• A decline in yield is also better for the equity markets because money starts flowing out of debt investments to equity investments.
• That means as bond yields go down, the equity markets tend to outperform by a bigger margin and as bond yields go up equity markets tend to falter.
• It says the yield on bonds is normally used as the risk-free rate when calculating the cost of capital.
• When bond yields go up, the cost of capital goes up.

When bond yields go up, it is a signal that corporates will have to pay a higher interest cost on debt. As debt servicing costs go higher, the risk of bankruptcy and default also increases and this typically makes mid-cap and highly leveraged companies vulnerable.

Why is the RBI keen on keeping yields in check?

The RBI has been aiming to keep yields lower as that reduces borrowing costs for the government while preventing any upward movement in lending rates in the market.

• A rise in bond yields will put pressure on interest rates in the banking system which will lead to a hike in lending rates.
• The RBI wants to keep interest rates steady to kick-start investments.

Where are yields headed?

Analysts say potential changes in the US monetary policy direction and Fed bond yields are the biggest risk factors for the Indian bond market in 2021.

• Notwithstanding this risk, bond yields may remain in a tight range in near future supported by RBI’s bond purchases.
• Over the medium term, inflation and potential monetary policy normalisation will play a more important role in shaping the interest rate trajectory.
• We expect market interest rates to move higher gradually over the next 1-2 years.

Is the RBI keeping the yield down a good idea?

For the Government, it is a good news because the overall borrowing costs go down.

• But, a section of economists aren’t comfortable with RBI artificially keeping the interest rates lower in the financial system as it will lead to distortions.
• In healthy economic system, the interest rates pricing should be driven by demand-supply, and shouldn’t be artificially suppressed by the central bank.

India’s macro position and external accounts are in much better shape than earlier. Nevertheless, Indian markets will not be immune to any such shocks in the global sphere.

Source: Indian Express