A case for tightening

Higher oil prices spooked the bond market on Tuesday, raising the yield on the 10-year government bond from 6.12 per cent to 6.20 per cent. That's not a big deal, considering that the year-on-year inflation figure is still near 8 per cent, but it's a healthy signal that the market is now on a downward course and that the recent rally in the bond market, which drove 10-year yields down from around 6.7 per cent to below 6 per cent, was an a temporary aberration.

At a time when inflation had moved up well beyond expectations, the gilts' misplaced rally owed its origin to the Reserve Bank of India's decision to allow banks to transfer securities to the "held to maturity" category, and to the optimistic talk of the inflation rate falling on account of the base effect.

These factors have now receded into the background""no bank wants to hold securities, especially long-term ones, while primary dealers have been selling across the board. As a matter of fact, the extent of damage to primary dealers is serious, as their second quarter results will show. For banks, there are no triggers to buy.

The market is now expects a rise in repo rates, to be announced possibly in the RBI's review of monetary policy next month. Liquidity has been tight in the market in the last few days, thanks to the advance tax collections on the one hand and the effect of the RBI's increase in the cash reserve ratio.

This has been reflected in the rise in call money rates in particular, and in short-term rates in general. They are also reflected in the lower amounts parked with the RBI in repos. Going forward, there are clear signals that the rise in non-food credit will impact bank liquidity.

Anecdotal evidence points to most of this rise being on account of retail disbursements, and companies still have plenty of cash.

However, scarcely a week passes without the announcement of a new project or expansion plan, and the real rise in credit disbursement will happen at that time.

At the same time, with inflation unlikely to come down by much (if at all), today's negative bond yields are unsustainable. The government's desire to prevent a choking of growth is understandable, but the rates in the market have to reflect reality.

What could be the positive factors in this scenario? One cushion is provided by the tax buoyancy. Government borrowing has so far been contained. Another cushion is provided by the RBI's market stabilisation bonds.

If the liquidity situation becomes too tight, all that the RBI has to do is stop using this instrument to mop up liquidity. Yet another ray of hope comes from foreign inflows. Recent data show that emerging market funds have once again started receiving dollar inflows, after a gap of several months.

The figures for FII inflows in the Indian market point to this modest pick-up. If the trend holds, it will provide a welcome source of additional dollars that can be translated into rupee liquidity if the RBI decides to mop them up. Nevertheless, there's little doubt that it's time to reverse the negative interest rates prevailing in the bond market.