What explains the Indian government borrowing at a higher interest rate than the interest rates for a home loan? The answer lies in the structural shortage in demand for government bonds. 

How the government’s cost of borrowing matter

• Interest on government debt is a transfer from taxpayers to savers who own government bonds.
• As the government bondholders are primarily domestic, interest paid by the government is just a transfer from one hand to the other within the economy.
• However, the government’s cost of borrowing does matter.
• The large increase in interest costs limits the government’s ability to spend elsewhere.
• But more importantly, this rate also affects the cost of borrowing for large parts of the economy.

Understanding the term premium and credit spread

• The RBI sets the repo rate, which is the short-term risk-free rate.
• That is, the loan must be repaid in a few days and there is almost no risk of default.
• The rate at which the government borrows is the long-term risk-free rate.
• But the lender wants higher returns given the longer duration of the loan.
• The difference between the repo rate and government’s borrowing cost, say on a 10-year loan, is called the term premium.
• When a private firm takes a 10-year loan, it would have some credit risk too, which means a credit spread is added to the 10-year risk-free rate.

Challenge posed by term premium

• From an average rate of 73 basis points since 2011 (one basis point is one-hundredth of a per cent), and 120 basis points in 2018 and 2019, the 10-year term premium is currently 215 basis points.
• In other words, the interest rate for a 10-year period borrowing is 2.15 per cent higher than the current repo rate.

How this is related to dysfunction in bond market in India

• Financial markets are forward-looking, and as the collective expression of the views of thousands of participants, efficient ones can occasionally “predict” what comes next.
• But the Indian bond market is not one such: The view some hold, that the rise in term premium reflects future rate hikes by the monetary policy committee (MPC), is mistaken.
• The Indian bond market is still too illiquid and not diverse enough to predict future trends.
• Even though some pandemic-driven measures are being withdrawn, the MPC continues to be accommodative, and for several months at least, headline inflation is unlikely to force an abrupt change.
• In any case, the spurt in yields after the budget points to the causality being fiscal instead of inflation-related.
• But even the fiscal rationale seems weak.
• The Centre’s tax collection for FY2020-21 has been substantially ahead of target, and state governments have also borrowed Rs 60,000 crore less than expected.
•  Also, the14 states, accounting for three-fourths of all state deficits, have budgeted FY2021-22 deficits at 3.3 per cent, far lower than the 4 per cent average expected earlier.
• Just these factors suggest that total bonds issued by the central and state governments should be lower than what the market had feared before the union budget was presented.
• And yet, government borrowing costs have not returned to pre-budget levels.
• This reflects dysfunction in the market.
• Why else would a government be borrowing at a higher cost than a mortgage on a house?

What is the reason for dysfunction in bond market

• Dysfunction can be traced to residential mortgages being among the most competitive of loan categories.
• On the other hand, there is a structural shortage in demand for government bonds.
• In such a market where there is a structural shortage in demand the marginal buyer holds all the cards, and as any buyer would, demands higher returns.
• Over 15 years,  the share of banks in the ownership of outstanding central government bonds has fallen from 53 per cent to 40 per cent now.
• But no alternative buyer of size has emerged to fill the space vacated.
• The RBI sometimes buys bonds to inject money into the economy, but of late this space has been used to buy dollars to save the rupee from appreciation.

Solutions

• The solution to the problem of bond market may lie in getting new types of buyers.
• The RBI opening up direct purchases by retail investors is a step in this direction, though it may not become meaningful for a few years.
• That leaves us with tapping foreign savings.
• The limit on share of government bonds that foreign portfolio investors (FPIs) can buy has been raised steadily.
• But without Indian bonds being included in global bond indices, these flows may not be meaningful, and would be volatile, as they have been over the past year.
• To enable inclusion in bond indices, the RBI and the government have earmarked special-category bonds which are fully accessible (FAR) by foreign investors.
• The FTSE putting India on a watch-list for “potential future inclusion” in the Emerging Markets Government Bonds Index is a step forward, and, one hopes, triggers similar actions by other index providers.

Consider the question “How the lack of retailness in the bond market affects the cost of borrowing of the government as well as the private borrowers? Suggest the measures to deal with the issues.”

Conclusion

The issues with bond markets in India highlights the urgency to find new buyers for government bond as it has implications not just for the government’s own fiscal space, but also for the cost of borrowing in the economy.

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