RBI repo cuts not effective any longer? They seem to have lost their sting

In 12 months, bond yields are down 100 bps, against 200-bps cut in repo

The rate cut by the Reserve Bank of India (RBI) seems to have lost its sting. The successive cuts in repo rate by the RBI have led to limited decline in the benchmark interest rate in the economy.

In the past 12 months, the RBI has cut is policy rate by 200 basis points (bps), from 6 per cent in June 2019 to 4 per cent.

However this has translated into 100-bps decline in yield on a 10-year government bond. The yield on a 10-year treasury is hovering around 6 per cent, against 7 per cent a year ago.

This is in line with the trend in the past five years, when the RBI policy rate has fallen quicker than bond yields. The central bank has halved its policy rate from 8 per cent at the beginning of 2015 to 4 per cent now.

However, this has translated into a 184-bps decline in yield on a 10-year government bond during the period, from 7.88 per cent in early 2015 to 6.04 per cent now. This has widened the spread between the repo rate and bond yield close to a historic high of 200 bps.

"Despite a 40-bps cut in repo rate by the RBI, the yield spread for 10-year bonds is now back to the March 2020 levels," says Devendra Pant, head economist, India Ratings & Research.

He expect bonds yields to remain at the current level or firm up in the coming months as the central and state governments scale-up borrowings to meet the shortfall in revenue due to the Covid-19 lockdown.

Yields could also get a lift from the growing mismatch between the government’s ambitious borrowing programme in 2020-21 (FY21) and household financial savings.

"It will be tough for the RBI to keep a lid on bond yields, as the gap between household financial savings and public borrowing narrows in the forthcoming quarters,” says Pant.

However, the RBI can supress yields somewhat by monetising deficit or directly financing the government borrowing programme.

Others see steeper rise in bond yields as economy activity resumes after the lockdown. "I expect bond yields to rise to 6.7 per cent in the next six months as the lifting of lockdown raises demand for bank credit from businesses and corporates. This, coupled with record borrowing by the government, means higher interest rate," says Dhananjay Sinha, director research, Systematix Group.

The central government has announced 54 per cent increase in market borrowings in FY21 to Rs 12 trillion. In addition, the government plans to borrow Rs 2.4 trillion from small savings.

Last week, the Centre also raised state government borrowings limit to 5 per cent of gross state domestic product, from 3 per cent. This will translate into total state borrowings of Rs 10.2 trillion in FY21, based on gross domestic product (GDP) figures for 2019-20 (FY20).

In comparison, household gross financial savings were Rs 20 trillion in F20, according to estimates by Business Standard based on GDP figures for the year. This figure is expected to either stagnate in FY21 or grow in low single digits, given GDP growth projections for the year.

Analysts say yields also remain relatively high due to selling by foreign institutional investors (FIIs). “FIIs withdrew close to nearly Rs 94,000 crore from the bond market in March, April, and May. This put upward pressure on the yield, nullifying the RBI’s efforts to lower interest rates,” says Sinha.

Any further rise in bond yields from the current levels would raise the borrowing cost for the government and corporates, making the task of economic recovery expensive and arduous.