Government securities market: Price discovery and the cost of Indian

The government securities (G-Secs) market has substantial effects on other markets as the producer of risk-free interest rate benchmarks. Over 2017-18, there was a sharp rise in the interest rates of 10-year G-Secs unrelated to fundamentals. This article explores its causes and sheds light on the working of G-Secs market in India, and on pitfalls of monetary management in an emerging market.

The government securities (G-Secs) market has substantial market impact as the producer of risk-free interest rate benchmarks. Price discovery in longer-term G-Secs gives an estimate of macroeconomic variables such as expected inflation and growth. RBI (Reserve Bank of India) open market operations (OMOs) in G-Secs play a major role in monetary management. OMOs are sales to or purchases from the market that adjust long-term rupee liquidity, also known as durable liquidity. Sale of securities sucks out rupee liquidity when it is in excess; while purchases increase liquidity when conditions are tight. Finally, the G-Secs market also affects the price of market borrowing for government. It can be argued that the RBI focus should only be on monetary management. But G-Secs rates and interest rate spreads matter more in monetary transmission as the share of bank credit goes down and that of market borrowings goes up.

Sharp rise in Indian government securities’ interest rates over 2017-18

The historical spread between the Repo¹ and the 10-year G-Sec since 2011 was about 60 basis points (bps) but rose to above 200 bps over 2017-18. Identifying the cause of this puzzle can shed light on the working of the G-Secs market in India, and on pitfalls of monetary management in an emerging market (EM).

Under the expectations theory of interest rates², long-rates are the sum of expected short-rates, plus a time-varying term-risk premium that depends on investor preferences. Real components and inflation components underlie the nominal yields, the nominal term premium, and the path for nominal expected short-rates. The standard explanation for a rise in long-term bond yields is market expectations of rising inflation and growth. Underlying this could be factors that push-up demand like rising fiscal deficits, or supply shocks like rising crude prices that affect inflation, thus raising expected policy rates. Demand and supply of securities affect price, but are themselves linked to fundamental factors. Policy rates directly affect short rates.

But examining each of the standard explanations shows them to be inadequate. Inflation remained within the targeting band. Growth was below expectations then rose and fell again. Fiscal slippages were mild. The US Federal Reserve’s tightening raised short-term yields more than the long-rate, and did not last long. Moreover, Indian policy rates were raised substantially on the inflation targeting path after 2013, so the differential between Indian and US rates remained adequate. Therefore, we turn to special features of Indian G-Secs market.

Special features of Indian government securities market

RBI automatically provides short-term liquidity on demand, largely to banks, under the liquidity adjustment facility (LAF). Banks meet the funding needs of the rest of the economy. In 2011 it was decided, following the practice in major advanced economies (AEs), to keep liquidity in deficit so that banks always had to borrow in short-term money markets, including from the LAF. But an EM like India with a sizable informal sector is subject to major autonomous shocks in durable liquidity from fluctuations in foreign inflows as well as from the demand for cash. So the share of durable liquidity can fall too low, for which short-term liquidity from the LAF is not a perfect substitute. Major sources of durable liquidity are the RBI’s holdings of G-Secs, which also raise demand for G-Secs, or its holdings of foreign securities acquired through foreign exchange intervention.

Since the call money market is uncollateralised, access is restricted only to banks and primary dealers. Therefore, it does not reflect system-wide durable liquidity deficits. Banks themselves depend more on deposits for liquidity than on the short-term interbank market. They prefer not to lend long-term based on interbank borrowing, since they are uncertain of future rates. Bank loans create deposits, therefore, as loan growth slows so does deposit growth. Moreover, sustained periods of liquidity deficit increase the leakage of cash, as informal rates of interest rise, thus making the deficit worse. An estimated DSGE (dynamic stochastic general equilibrium) model³for India finds apart from interest rates, money aggregates also significantly affect aggregate demand, unlike in AEs. The income elasticity of narrow (reserve) money⁴ is three times that of broad money⁵ (Goyal and Kumar 2018). Therefore, both money supply and the share of reserve money matter for an economy like India. It is not enough just to target interest rates.

There were periodic complaints of liquidity shortage from markets. In 2016, therefore, it was decided to keep the LAF in neutral position by creating more durable liquidity. Yet 2017 again saw complaints. The LAF fluctuated between surplus and deficit liquidity.

As caps on debt flows were lifted, US$19 billion came in over 2017-18 up to the limits allowed. They gained from India’s higher interest rates and currency appreciation, but did not reduce the cost of government borrowing since the RBI had to accumulate excess inflows as reserves, substituting low-yielding US treasuries for Indian G-Secs. The source of durable liquidity from the asset side of the RBI balance sheet, therefore, also matters. The share of G-Secs to foreign securities in the RBI balance sheet became negative in periods of large inflows, and these were also periods when G-Sec yields rose. The ratio reached a low of 0.15 on 23 February 2018.

Sustained outflows in foreign debt investments in 2013 and in late 2017 were due to global risk-off. In both periods, Indian market positions were largely long in government securities as interest rates were in a downward phase. As policy raised rates partly to mitigate debt fund outflows, bond values fell creating large domestic market losses. Shrinking domestic institutional and retail participation in debt further raised G-Sec rates. Regulatory actions such as reducing the share of banks’ G-Sec holdings allowed to be held to maturity, just as rates rose also made them reluctant to hold G-Secs. As liquidity dries up banks’ demand for G-Secs falls. As Indian interest rates rose following the rise in US Fed rates, it hurt the domestic cycle.

The US Treasury would like all EM adjustment in response to capital flows to be in exchange rates since local currency appreciation expands US exports. It dislikes market interventions and threatens to label a country as a ‘currency manipulator’ to pressurise it to appreciate its currency. In 2017, it put India on the currency manipulator watchlist since its purchase of US$ totalled 2.2% of GDP (gross domestic product), but this was necessitated by a relaxation of controls on foreign inflows and India had a current account deficit – a further perverse effect of the relaxation.

The large swing in RBI positions from selling G-Secs to sterilising acquisition of foreign currency to acquiring above 60% of net government borrowing through OMOs, and other regulatory actions, offer more satisfactory explanations for distortions in yields from fundamentals. In addition to policy rates, the provision of durable liquidity, share of reserve money and its sources also affect G-Sec yields as well as broader economic outcomes. Expanding operational targets to include reserve money and its sources would be consistent with flexible inflation targeting, since everything that affects the inflation target can be considered.

Event analysis and formal regressions (Goyal 2019) support these hypotheses. Contextual variables discussed also help to explain the yield deviation. Repo rates had a larger effect on short- compared to long-rates. That domestic long-rates are still protected from global volatility implies policy has some independence.

Policy implications

The narrow focus of monetary operating procedures was inappropriate for many aspects of Indian structure. Large exogenous durable liquidity shocks require a more rapid adjustment of durable liquidity. OMOs must not be seen only as a residual durable liquidity management tool, but as affecting the spread of interest rates and therefore the transmission of monetary policy. They should never be entirely replaced by acquisition of foreign securities. The price discovery function of G-Sec markets is impeded both by too little and too much of OMOs, so balance is required. While development, deepening and stability of financial markets must remain a major objective, tightening of regulations should avoid being pro-cyclical. Attention should be paid to making micro and macro regulations more counter-cyclical and context-based, and to improving communication.

Foreign investors are an additional source of finance and market deepening but they add volatility especially in thin markets. A low cap of 5% of domestic debt leads to debt stocks being too large a share of foreign liabilities. This share should also be capped. Such capital flow management, prudential regulations, a flexible exchange rate, as well as reserve accumulation and use are all ways to retain independence of monetary policy to focus on the domestic cycle.

The debate on an independent debt office needs revisiting. International views earlier favoured independence because of possible conflicts of interest but swung around to seeing Central Banks (CBs) as better debt managers given their advantages of strategic timing of placements and use of market intelligence. The change followed large post-GFC (Global Financial Crisis) expansion in AEs’ CB debt-holdings. Reducing cost of government borrowing is an aim of the debt manager but need not imply automatic funding of deficits. The critical difference of freedom in use of OMOs remains, unlike the earlier automatic ad-hoc treasury bills, which were discontinued in the nineties.

Notes:

Repo rate is the rate at which the RBI lends money to commercial banks.
The expectations theory of interest rates links the return to holding a long-term bond to the expected future return on a series of short-term bonds.
The DSGE framework is one of the most influential and prolific areas of research in monetary policy analysis. The DSGE model is the workhorse model for the analysis of monetary policy at major central banks.
The sum of currency in circulation and demand deposits with banks is called narrow money.
The sum of narrow money and time deposits with commercial banks is called broad money.