With just over a month left in FY21, the market is still expecting a consolidated borrowing amount of more than Rs 2.5 lakh crore as per the auction calendar of Centre and states. The average increase in G-sec yields across 3-,5- and 10-year bonds is around 31 basis points since the Budget. ‘AAA’-rated corporate bond and SDL spreads have jumped by 25-41 basis points during this period.
While this significant increase in bond spreads is the manifestation of nervousness among market players, we believe the central bank will have to resort to unconventional tools to control the surge in bond market yields. This is important, as any further upward movement in G-sec yields even by 10 bps from the current levels could usher in mark-to-market losses for banks, which could be a minor blip in a rather wise exceptional year in FY21 bond market, with RBI assiduously supporting debt management of the government at lowest possible cost in 16 years, which could have otherwise threatened financial stability.
In fact, the RBI strategy of devolving on the primary dealers may have its limitations as standalone PDs (primary dealers) account for 15-16% of secondary market share, which may not be enough to move the market. This share has remained broadly consistent over a long period despite excessive market volatility.
One of reasons for the recent surge in yields might be short selling by market players. While going short or long are typical market activities that aid price discovery, at times it can result in price distortions too, as it might be happening now. The strategy of short selling involves the sale of a security, which the seller has not yet purchased, but borrowed from others through the CROMS platform of CCIL. Banks and primary dealers resort to short selling when their view is bearish – that is, they expect the prices of bonds to fall and yields to rise.
They make money if the bond prices drop and yields rise, and over time this could become a self-fulfilling prophecy, as such short sellers keep on rolling over their borrowed security from the repo market till the time they believe the yields will continue to rise. The only way to break such self-fulfilling expectations is for RBI to conduct large-scale OMOs to provide the necessary steam to bond market to rally and with an increase in price, many short-sold positions will trigger stop losses and market players will scramble to cover open positions. This will hasten a rapid fall in yields within a short time.
Specifically, RBI can think of the following steps:
- Speaking to market players /Off market interventions: This will also fulfill the desired objective of RBI avoiding devolvement at auctions.
- OMO in illiquid security: OMO in illiquid security will help shorters (hedgers) to get relieved of those holding in OMO and unwinding of short position will happen, if the selling pressure is matched by an equivalent or better buying pressures from the market participants. Announcing a weekly outright OMO calendar of Rs 10000 crore till March end will be helpful.
- Stopping VRR rollover: With even short end Gsec yield (3yr Gsec at 4.9% & 5yr Gsec at 5.85%), Corp bond yields higher too (3yr AAA at 5.55%) the entire benefit of accommodative stance is neutralized. VRR is not helping in overnight rates as can be seen in last week treps rate which was averaging 2.4%.
- Holding period: Time period for covering short sale may be reduced from 90 days to 30 days.
- Margin Requirement: Margin requirement for borrowing securities in repo market while covering the short sale position may help. Short sellers may deposit collateral to the tune of 150% of value of short security.
- Limit reduction: Security level limit may be reduced to 1% of outstanding stock (or Rs 300 crore) of each security in case of liquid securities and 0.5% (or Rs 150 crore) in case of illiquid securities.
- Allowing More players: Allowing more players such as mutual funds and insurance companies in the repo market.
- Penalizing short sellers: The short sellers are even willing to give the money at 0.01% for borrowing bonds. Can we have not a system of negative interest that will make the transaction even costlier for them? RBI can also supply bonds in the repo market to the short sellers if it has the stock.
It must be greatly appreciated that RBI has used all tools at its disposal in FY21 to manage a humongous government borrowing programme that perhaps was not the case prior to it, particularly during FY17-19. The market has, however, moved a step ahead of RBI post-Budget. It is now time for the central bank to align the market expectations with its stated objective. As the saying goes, “Monetary policy is the art of managing expectations and little else.” – Michael Woodford, Professor, Colombia University. True indeed!
(Dr Soumya Kanti Ghosh is the Group Chief Economic Adviser of State Bank of India. Views are his own)