Keeping yields low when inflation is rising is risky

The Reserve Bank of India (RBI) may be the government’s debt manager, but the central bank must be pragmatic and play fair. If the government wants to borrow large sums to fuel its spending plans, it must pay the asking rate. Doesn’t every other borrower—a firm, an individual, a bank, an intermediary—pay the market price? Like every lender, the bond markets, too, are justified in asking for a better rate for their money.

The central bank has been seeking their cooperation in seeing through the government’s borrowing programme, but the bond markets seem unwilling to give up their fair share of returns. Of late, the sell-off in the markets has intensified, pushing up the yield on the benchmark bond up by some 14 basis points (bps) in one week and a chunky 6bps on Monday, to levels of 6.20%. RBI has been hoping to rein in the yield at 6% to try and ensure that the government’s interest bill remains in check.

However, the responses to the auctions of government securities have been lukewarm with large devolvements. It shouldn’t be surprising if the yield nudges 6.5%, as some experts believe they will, in the next few months given the supply of paper; the Centre plans to borrow a mammoth Rs 12 lakh crore in FY22 on the back of Rs 14 lakh crore in FY21 and in addition, there is the supply of bonds from state governments.

So far, the large surplus liquidity—averaging about Rs 4 lakh crore so far this fisc—has helped support government borrowings. The liquidity results from RBI buying dollars to boost reserves and deposits growing at a fast clip at a time when loan growth has been slow. But, as the economic recovery progresses and demand for credit grows, banks are likely to lend more to earn better returns and invest less in SLR securities. For now, RBI can try and stem the yield by buying more bonds—it has bought Rs 3 lakh crore of bonds in FY21 so far—but how much more can it buy when, to control inflation, it will need to move away from the more-than accommodative liquidity stance.

This is not the first time RBI has tried to control yields, but the fundamental conflict between RBI’s role as the government’s debt manager and its inflation-targeting goal gets shown up the most when inflation is rising as it is now; how can RBI be seen as trying to target inflation when, at the same time, it is trying to keep the 10-year yield low?

The bond markets cannot afford to ignore the writing on the wall. The sharp spike in prices of key commodities, like crude oil, is expected to stoke inflationary pressures. Even if oil prices taper off globally, in India, the high duties will keep prices of auto fuels elevated; little wonder RBI Governor Shaktikanta Das has called upon the central and state governments to address this issue by cutting their levies.

Apart from the issue of RBI’s credibility, leaving yields at artificially depressed levels at a time when the economy is expanding could also be harmful in the medium-term. Real interest rates, especially at the shorter end, have been negative for far too long, favouring borrowers and hurting savers.