Explainer: What is Going on in the Bond Market?
Rajendra Gill 23 March 2021
Last week, the Reserve Bank of India (RBI) shook the bond market, thanks to some extraordinary comments in RBI Bulletin of March 2021 in the article “State of the Economy”. The article, which deploys some colourful prose that is unusual coming from a central bank, says, “Five developments marked the onset of March. First, calm returned after the flash bond sell-offs globally and in India that heralded the arrival of March, prompting a calling out of vigilantes who have returned to prowl markets, guns holstered and saddled up.”
 
It goes on to describe how the benchmark 10-year had surged to 6.13% in February but calmed down after a slew of measured announced by RBI.
 
The article further says, “The pandemic stirs a heady cocktail—fiscal stimulus; monetary accommodation; release of pent-up demand; vaccine rollout - on which the bond vigilantes thrive. As growth forecasts for 2021 are ratcheted up, they see in them the spectre of long dormant inflation, the arch enemy of bonds as it erodes the real value of the fixed income they provide. With these latent anxieties, bond vigilantes turn sceptical about the central bank’s promise to remain accommodative and start the rout.”
 
The article warns that “bond vigilantes are riding again, ostensibly trying to enforce law and order on lawless governments and central banks but this time around, they could undermine the economic recovery and unsettle buoyant financial markets.” 
 
Quoting governor Shaktikanta Das’ comment that “An orderly evolution of the yield curve has to be orderly; it cannot be otherwise…” the bulletin says “there is much sense in what the Reserve Bank is doing in striving to ensure an orderly evolution of the yield curve. But it takes two to tango and forestall a tandav.” 
 
In a warning of sorts, it says, “This type of calming forward guidance from central banks also hides a tension - their nerves can fray if they see a painfully extracted economic revival, and financial stability built at the altar of regulatory forbearance, threatened by adventurism. Will they engage in more aggressive actions? After all, they hold the Brahmastra - asset purchases. If bond yields get too high, the relentless weight of bond purchases by central banks will stabilise markets, but at the cost of market activity.” 
 
The present governor of RBI appears to believe in the Socratic method of public debate. He has exhorted the Indian bond market “not to be bitter but to be better.” He calls for an “orderly evolution of the yield curve” because he believes this is a public good. 
 
So, in the best Socratic tradition of disputation and public debate, let us get into “questioning the questions,” as one of his predecessors, governor D Subbarao, had said in his JRD Tata memorial lecture of the same title on 31 July 2009. Here is my explainer in the form of a set of questions.
 
1) Why is the RBI fretting and fuming?
 
The Central and state governments have been the largest, continue to become even larger, borrowers from the local debt market. The buyers of this sovereign debt are mainly public sector banks (PSBs), pension funds, mutual funds and insurance companies, who channel the savings of citizens. 
 
The borrowing requirement of the Centre and states has increased substantially during the COVID-19 pandemic and buyers of public debt are demanding a reasonable return, which is determined at the weekly public debt auctions conducted by RBI. 
 
It appears that RBI finds this demand for a ‘reasonable return’ unacceptable and believes that it is the best judge of what should be a reasonable rate of return. By its reckoning, the 10-year borrowing rate for the government of India (GoI) ought to be 6% and no more. 
 
What gives RBI the oracular wisdom and foresight to determine that this is a reasonable rate when buyers of debt believe it ought to be 6.25% or 6.50% or 7%? 
 
The turmoil in the bond market, which is attributed to bond market vigilantes, is due to the fact that diktats do not work in a public auction. 
 
2) Who are the bond market vigilantes? 
 
The expression bond market vigilantes sounds ominous and conveys the sense of a group of anti-national individuals who are in a conspiracy to stall and undermine India’s 'nascent recovery.' 
 
There is nothing demonic about bond market vigilantes. They are the very same domestic banks, pension funds, insurance companies and mutual funds that channel domestic savings to finance government borrowing programmes. 
 
By denying domestic savers a reasonable, market-determined return on public debt, RBI is actually weakening our collective atmanirbharta resolve.
 
3) What is the reasonable return on public debt?
 
The best measure of a reasonable rate of return on public debt is the return determined when demand and supply for debt matches at the weekly auction of public debt conducted by RBI. 
 
This auction-determined, market-clearing rate is indeed the reasonable return as it substantially embeds all the information that matters. This information pertains to the current and future expectations about inflation, both wholesale inflation (WPI) and retail inflation (CPI). 
 
Expected inflation (ex-ante inflation, as economists like to call it) is an important driver in determining the reasonable rate of return as buyers of debt, who channel domestic savings of Indian citizens, seek a positive inflation-adjusted rate of return. 
 
In addition to expected inflation (ex-ante inflation) the public auction process reflects the investor assessment with respect to global economic environment. Right now, they would like to know if inflation is due to increase globally on account of actions by governments to spend and borrow in large amounts and the impact this spending has on price of intermediate goods (commodities like oil, copper, steel) and final goods in turn. 
 
Public auction of public debt expresses with clarity the demand and return preferences of the buyers of public debt. 
 
These preferences incorporate the collective assessment of the buyers of debt. This is the demand function of public debt. The supply function of public debt is determined by the needs and requirements of the issuer of the debt, GoI, the principal issuer of public debt. 
 
As the requirement of GoI keeps growing on account of the need to finance larger and growing budget deficits, the supply of debt on offer too increases. Given the demand function for public debt it is to be expected that the market clearing price, the rate of return, the interest rate on public debt, should rise till the supply clears. 
 
This is broadly how the reasonable rate of interest gets determined in a public auction.
 
4) Why is the RBI the manager of government debt? 
 
RBI is both a regulator of financial institutions and a manager of the government borrowings. There is a conflict of interest in this situation. 
 
RBI’s role as a fit and proper (and fair) referee who balances the interests of borrowers and savers requires it to enable a publicly determined auction rate to be established in the public debt markets. This is the way to discover a reasonable rate of return. 
 
A market-determined reasonable rate of return is often deemed an unreasonable rate of interest by borrowers in general and certainly by the principal borrower, viz, GoI. 
 
RBI as a debt manager, merchant banker, broker, steps in and arbitrarily determines the reasonable rate of interest that GOI should pay on its borrowings.
 
5) Is this financial repression? 
 
Yes, when RBI using its oracular wisdom decides that the rate of interest on the 10-year government borrowings should be 6% and not 7% (as the buyers may demand in a public auction), RBI is thus enabling financial repression. 
 
6) What is wrong with financial repression? Doesn’t the country benefit? 
 
Financial repression is intended to benefit only the borrowers and, as a rule, short changes the savers. This is completely contrary to our espoused national objective of atma-nirbharta. 
 
Financial repression weakens the nation. Financial repression enables shaky borrowers to defer putting their house in order. It is only the market determined reasonable rate of return that disciplines borrowers, be it the GOI, the public sector or the private sector. 
 
A spendthrift borrower faces the consequences when the buyers of debt ask for a higher rate of interest for the risk.
 
7) Is financial repression a public good? 
 
The RBI governor has submitted that financial repression (the orderly evolution of the yield curve, is his expression for financial repression) is a public good and therefore in the public interest. 
 
If we examine the previous questions and the related observations then it is evident that financial repression instead of being a public good is the principal source of financial instability and rising income inequalities. 
 
The evidence is there in the developed world where central banks have opted for financial repression by creating a ZIRP (zero interest rate policy) environment.
 
8) If financial repression has failed to engender investment, stable growth, better employment in the developed world, why do central banks persist in it? 
 
Hubris. Institutional arrogance stemming from unelected power of central bankers has ensured that there are no consequences, professionally, for central bankers for their actions. 
 
Unlike elected representatives who need to be returned or rejected in every election cycle, central bankers have immunity, which fosters institutional arrogance and willful blindness.
 
9) Why is no one calling it financial repression?
 
Because though it is the truth, it sounds terrible. So we deploy various catchy and confusing euphemisms. These are:
 
a) Orderly evolution of the yield curve: RBI governor decides that the 10-year borrowing rate will be 6%, then may be, just may be, 6.25%. Certainly not 6.50% or 7% that the bond vigilantes may determine as a reasonable rate of interest.
 
b) SMA (special market operations): Another tool to enforce what the governor decrees.
 
c) Operation Twist: Certainly not a tango. But a tandav to again enforce what the governor decrees.
 
d) Forward Guidance: Public reprimanding and declaiming against bond market vigilantes who are merely requesting for a reasonable rate of interest.
 
e) Adventurism: The tango for a reasonable rate of return is characterised as adventurism.
 
10) Why does Michael Patra, the deputy governor, in the latest RBI Bulletin talks about tango and tandav?
 
Yes indeed. It takes two to tango. The bond vigilantes are dutifully following all the sophisticated and graceful rules of tango. It is RBI, which is doing a tandav. Financial repression is the tandav.
 
11) What is the implication of monetary policy and related liquidity management measures? 
 
RBI has caused a collapse of the short term, money market term structure of interest rates. This is RBI’s tandav in the money market. 
 
To argue that extraordinary times (pandemic), demand extraordinary measures, such as flooding the banking system with liquidity, is disingenuous and misleading. The pandemic has created a loss of income related solvency crisis, not a liquidity crisis. Solvency crisis can never be addressed by monetary policy measures that flood banks with liquidity. 
 
Banks have the liquidity. But basic commercial risk management deters them from financing semi-insolvent and insolvent borrowers. Solvency issues have to be addressed through direct income support and through debt relief and rehabilitation. 
 
This is the domain of fiscal policy where GoI needs to step in and act directly with urgency. GoI cannot substitute its fiscal policy inaction with monetary policy-based on financial repression. By opting for financial repression, RBI is endorsing a mis-pricing of risk. 
 
As a result, the flood of liquidity with banks only reluctantly and sparingly reaches the stressed borrowers. The principal beneficiaries are the good borrowers who are re-financing existing high-cost debt with very low-cost borrowings. 
 
Has it benefited the economy? Doubtful. Because at the end of the day monetary policy is pushing on a string. Therefore, the expression, “You can lead a horse to water but you cannot make him drink.”
 
(Rajendra Gill-An ex-TAS (Tata Administrative Services) Officer with two decades’ experience in the financial markets. He is a whole-time director with VMS Consultants Pvt Ltd, an expertise-based structural engineering design consulting practice in Mumbai.)
Comments
Ramesh Popat
4 years ago
analysis with shashi tharoor touch!
Kamal Garg
4 years ago
Quite detailed and catch-on on the latest in the bond market.
By the way, all those economies including Japan and US, who are practicing low/zero interest rate regime are finding it very hard to come out of their respective recession.
Market is the right determinant of money and liquidity with roughly no/very less interference by the central bank.
It is wrong also to deny the savers their rightful interest rate, more particularly in a high inflation economic scenario.
baskarans53
4 years ago
Hard hitting and lucid. Love this Q & A.
rajneesh
4 years ago
amazing
hamungel
4 years ago
Very well explained. I request Mr. Gill to continue writing more articles in the same manner.
sharmaorajesh
4 years ago
The liquidity of a bank is described as the ratio of liquid assets to its immediate maturing (30 days) liabilities. There are other similar ratios.
This can extrapolated for the system as whole. The collapse of Yes Bank caused deposits to move from Yes to other banks and in the process Yes reduced its exposure to private debt. The banks which received those deposits did not pick up the private debts shed by Yes but invested in government paper. In short we have due to the pandemic seen a rise in the ratio of banks investments in government paper - this has brought the interest rates down for the GOI.

With pandemic receding- and survivors and stronger corporates picking up business of the failed businesses demand and opportunity for the banks to get better yield by lending to these corporates is rising.

RBI sees that as a threat for its main customer - that is the GOI ! It’s now seeking to pretend that the uptick in business is due to the low rate of interest and will be harmed !
Fact is corporates find that business returns are juicy even after paying slightly higher rates of interest !!

Corporates are ready to tango with banks and the so the tandav from the jilted RBI !!
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