Indian economists are in a dilemma these days. On one hand, Indian economy is witnessing high growth levels of 7-7.5 per cent accompanied by a desirable low inflation rate. On the other hand, corporate earnings and Indian exports do not agree with these figures. Both exports and imports are dwindling and Indian industry is experiencing low growth in profits. Further, the country’s rural economy is a distress, resulting in undesired low rates of private consumption. For improving the private consumption, it is necessary that government increases its fiscal spending in the rural areas, as can be seen in the Union Budget, 2016. Moreover, the reduction in repo rate by RBI has been welcomed. However, the Indian economy continues to show signs of weakness, which is likely to harden the bond yields.

 

Since the beginning of calendar year 2015, rapid disinflation owing to the fall in global crude and commodity prices has helped the Reserve Bank of India (RBI) continue its monetary accommodation with reduction in policy rates by 125 basis points (bps). Though RBI has substantially reduced the policy rate to 6.75 per cent, yield on the 10-year benchmark government securities (G-Secs), considered as the safest investments, still holds at near 7.8 per cent. In fact, yield spread of state government securities over central G-Secs has widened from around 45 bps to 70 bps. It is known that higher the yield spread, higher the attractiveness of investment.

 

One of the major reasons for such a trend is with respect to demand-supply mismatch. On the supply side, fiscal consolidation has ensured net dated supply at nearly the same level as for the past five years (from INR 4.36 trillion in FY12 to INR 4.4 trillion in FY16). However, the demand side story is not at all encouraging. Over the same period, this has almost doubled (from INR 1.45 trillion in FY12 to INR 2.78 trillion in FY16). This means that there is excessive capacity in the economy. In a scenario of excessive supply, bond yields are bound to show declining trend.

 

In addition to the supply-demand mismatch, banking sector’s aggregate deposit growth in percentage terms has come down from 25 per cent in 2008 to around 10 per cent in 2015. Further, Statutory Liquidity Ratio (SLR) requirement has been steadily reduced over the years from 25 per cent as on November 2009 to 21.5 per cent as on February 2015. The combined effect of all these have resulted in lower demand from the banking sector. In FY15, banking sector’s net purchase of G-Secs and state development loan (SDL), or state government bonds, was only INR 1.88 trillion, less than the seven year average of INR 2 trillion, and significantly lower than INR 3.2 trillion in FY14.

 

Hence, the present situation can change only if global growth picks up and there is a flow of capital in the economy. FIIs definitely need to improve their investments for a roundabout turn of the undesired prevailing factors in the economy. Besides FIIs, other members of the investing community such as mutual funds and corporate investors also need to show substantial growth.

 

Given the market dynamics of supply far outstripping demand, we may witness bear (falling) steepening of the yield curve. In such a scenario, it is expected that government will flood the market with bonds and this will result in additional government borrowing. For example, in order to fund Gross Domestic Product (GDP) growth of even around 6 per cent (as per the old series), RBI needs to inject primary liquidity of around INR 2 trillion. Consequently, this requirement of huge sums of money clearly necessitates injection of primary liquidity through purchase of domestic assets to make up for the shortfall incurred because of Open Market Operations.

 

Thus, better transmission of monetary policy impulses, perhaps through an accommodative liquidity injection/ open market operations (OMOs) by RBI may help Indian economy improve its overall scenario.