Why is RBI having a tough ride in keeping bond yields in check?


Post the Union Budget on February 1, 2021, RBI is under pressure to keep the bond traders calm. Though a higher fiscal deficit was expected, it rose to 9.5 per cent as a percentage of GDP for FY21 and is projected to touch 6.8 per cent in FY22, which came as a surprise. Equity markets gave a thumbs-up to the Budget, but a higher fiscal deficit was a daunting news for the bond market, leading to a surge in bond yields.

Market borrowing of the central government is projected at Rs 12 lakh crore in FY22. To facilitate the government market borrowing programme, RBI has also allowed retail investors to open gilt account with RBI. Increased supply of government bonds in the    market could lead to demand-supply mismatches,putting pressure on yields.

As investors in the government bonds are getting higher yields, the same will be demanded on corporate bonds. This, in turn, leads to increased borrowing cost for corporates, negatively impacting private investments in the country. Similarly, higher bond yields could further complicate the transmission of rate cuts by the central bank.

The onus is now on RBI to keep a check on bond yields. In the last bimonthly monetary policy meeting (MPC), no major announcements were made in this regard. However, the RBI governor reiterated that the evolution of an orderly yield curve as a public good. As the economy is gradually recovering from the recessionary phase, the fear of rising inflation is getting stronger.

For instance, inflation rate as measured by consumer

 price index (CPI) was at a 16-month low of 4.06 per cent in January. On the other hand, core inflation (i.e. inflation excluding food and fuel) grew 5.7 per cent in January. Rising fuel price is also building up inflationary pressure on the economy. In such a scenario, there won’t be any further rate cuts in the near term. The RBI Governor has assured that its accommodative stance will be maintained as long as necessary to bring the economy back to the growth trajectory.

Yet, the restoration of cash reserve ratio (CRR) in two phases beginning March 2021 could be seen as the first step towards normalisation of monetary policy. This could even put more pressure on bond yields. In this background, the central bank announced the next round of ‘Operation Twist’ to be conducted on February 25, 2021.

‘Operation Twist’ is nothing but open market operations (OMOs) where RBI would be conducting simultaneous purchase and sale of government securities. Through the purchase of long-term bonds, RBI aims to push down the bond yields. And, it would support the market borrowing programme of the government.

In the current scenario, RBI would be having a tough ride in keeping the yields in check. The central bank has to deal with inflation worries along with the increased market borrowing from both the central and state governments. RBI needs to actively participate in the bond market and communicate it to market participants to ensure that the bond yields are in check.

Article first published in Economic Times.


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