Budget 2021 has heated up the bond market. This is how RBI can cool it down

There is an outside chance of the central bank announcing a rate cut in its monetary policy on Friday, since growth at any cost remains the mantra

There was a sharp rise in yields on government bonds after Finance Minister Nirmala Sitharaman announced high borrowing numbers in her Budget for 2021-22. Now, the Reserve Bank of India (RBI) may be prompted to unveil measures to cool the yields down in order to keep the cost of funds in check.

The bond market got a negative surprise on Monday when the government projected its gross borrowing numbers for next financial year at Rs 12.05 trillion, much higher than the expected Rs 10.5 trillion. To make the matter worse, the government said it would borrow an additional Rs 80,000 crore in the current financial year, too. 

“The Rs 80,000 crore extra borrowing for this year is especially a bolt from the blue for the bond market,” said Suyash Choudhary, head of fixed income at IDFC Asset Management Company, in a note. “This is because the government has been consistently running very high cash balances lately, revenues have picked up dramatically, and even though spending has gone up, it hasn’t been tracking anywhere close to what is required to yield the revised Budget numbers.” 

After rising 22 basis points through Monday and Tuesday, the yield on the 10-year government bond dropped by 4 basis points on Wednesday to 6.08 per cent, in anticipation of some measures from the Reserve Bank of India (RBI) in the monetary policy review, which is currently underway. The outcome of the review will be announced on Friday.

OMO calendar

So what are the options before the RBI to cool the yields down?

One of the options could be to announce an open market operations (OMO) calendar for purchasing government bonds. Even as it has conducted OMOs of such a nature in the past, the central bank has refrained from announcing a schedule, preferring to maintain an element of surprise.

“Communication will be the key. Certainly, RBI will not be comfortable with the spikes that we have seen in the bond market,” Emkay Global economist Madhavi Arora told Business Standard. “One of the ways to ease the market is to hint at an OMO calendar — in the medium term, if not immediately — because there will be a huge G-sec supply that will hit the market. They would look rational to believe that inflation is going to come down substantially and signal further policy action.” 

After staying above the RBI’s upper tolerance band of 6 per cent for eight months, retail inflation dropped to 4.6 per cent in December. The RBI’s monetary policy has a mandate to maintain the rate of consumer price index (CPI) -based inflation at 4 per cent, with a variation of +/- 2 per cent on either side.

Radhika Rao, economist with the DBS Group, said the central bank was likely to receive some relief from inflation, which eased to a sub-5 per cent level in December after staying above the inflation target range for eight straight months. “While the Budget is unlikely to stoke inflation per se, pre-existing forces by way of higher input costs, commodity price increase and demand impulses would keep FY22 inflation above 4 per cent,” she said.

Rate cut

Since inflation is likely to stay within the 2-6 per cent range in the medium term, will the central bank be prompted to frontload its rate cut, especially as the policy makers have indicated a thrust on pushing growth, even in the Union Budget?

“We think the recent drop in CPI-based inflation opens the door for a cut” said Mitul Kotecha, senior emerging markets strategist at TD Securities, in a note to clients. “The RBI is likely to try to provide some relief to bonds,” Kotecha said. TD Securities expect a 25-basis-point cut in the repo rate to 3.75 per cent, even as there seem a market consensus of a status quo. (100 bps = 1 percentage point). 

RBI has reduced the repo rate by a cumulative 250 bps in the current rate-easing cycle, which started in February 2019 – the first monetary policy review under the current governor, Shaktikanta Das. Under Das, the central bank has been proactive in reducing interest rate as it saw a slowdown early. However, interest rates have been kept unchanged in the past three policy review meetings – in August, October and December 2020.

India’s gross domestic product (GDP) growth, which plummeted to 4.2 per cent in FY20, turned negative in the first two quarters of the current financial year, and the Economic Survey released before the Budget projected 7.7 per cent contraction in the current financial year, and 11 per cent growth in the next (FY22).

Hike in HTM Limit

Another option to keep the yields under check is to increase the banks’ held-to-maturity limit for securities. “We expect the RBI to hike banks' HTM limit by 4 per cent of their book (from 2 per cent) to incentivise them to invest their surplus money market liquidity (of $86 billion) into G-Secs,” BoFA Securities said in a note while explaining how the higher fiscal deficit could be funded. The fiscal deficit is pegged at 9.5 per cent for the current financial year, and 6.8 per cent for FY22.