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Government Securities Market
Over 2017–18, there was a sharp rise in Indian government securities interest rates unrelated to fundamentals. Examining each of the standard explanatory variables shows them to be inadequate to account for the rise in bond yields in this period. Turning to aspects of Indian structure, the reason is found to be the narrow focus of monetary operating procedures, with excessive reliance on making up liquidity shortfalls with short-term liquidity, which was inadequate given large exogenous durable liquidity shocks, including foreign inflows. The composition of liquidity, share of reserve money and its sources all matter. Open market operations have a significant impact on yields. Large foreign debt inflows induce open market operations sales as G-Secs are swapped for foreign securities to sterilise the effect of inflows on the money supply. G-Secs yields are then found to rise.
A brief version of this paper was presented as the NSE-IEA Lecture Series on Financial Economics at the 101st meeting of the Indian Economic Association in VIT, Vellore, Tamil Nadu, 28 December 2018. The author wishes to thank Nirmal Mohanty for the invitation, participants for useful feedback, the referee for useful comments, Deepak Agarwal and Akhilesh Varma for research assistance, and Reshma Aguiar for secretarial assistance.
The government securities (G-Secs) market is little understood, yet has substantial effects on other markets as the producer of risk-free interest rates that serve as benchmarks for bonds, more generally. Price discovery in the longer term G-Secs gives an estimate of macroeconomic variables such as expected inflation and growth. It has a major role in monetary management. The Reserve Bank of India (RBI) conducts open market operations (OMOs) in G-Secs, that is, sale to or purchase from the market in order to adjust long-term or durable rupee liquidity. Sale of securities aims to suck out rupee liquidity when it is in excess; while buying securities from the market releases liquidity into the market when liquidity conditions are tight. Finally, it also determines the price of market borrowing for government. It can be argued that the RBI should not worry about this and focus only on monetary management. But, G-Secs rates are becoming more important in monetary transmission as the share of bank credit goes down and that of market borrowings goes up. Market interest rate spreads affect monetary transmission.
The 10-year G-Secs threw up an interesting puzzle last year. There was a sharp rise in yields unrelated to fundamentals. Exploring its causes sheds light on the working of G-Secs markets in India, and on pitfalls of monetary management in an emerging market. The following figures give a quick overview of the G-Secs market and put the sources of government financing in context. On 17 December 2018, all G-Secs totalled to ₹ 54.43 trillion. Commercial banks were the major holders with ₹ 26 trillion in 2016. In end November 2018, the RBI held only ₹ 7.85 trillion of this, which itself was up from ₹ 4.74 trillion in end March, while foreign institutional investors (FIIs) held ₹ 1.91 trillion. Other holders and players include insurance companies—provident and pension funds, cooperative banks, regional rural banks, mutual funds and corporates. Retail at present has a minor share, although there are continuing attempts to develop the retail market. Stock exchanges have launched debt trading platforms (G-Secs as well as corporate bonds) for retail investors, with access through broker banks.
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