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The Bond Market Trick

The rate of return on government bonds becomes the benchmark for deposits raised by banks

Business lobbies in this country are constantly talking about the fact that the Reserve Bank of India (RBI) needs to cut interest rates. But the RBI has not heeded to their ramblings in the recent past. In fact, on January 28, 2014, the RBI raised the repo rate by 25 basis points (one basis point is one hundredth of a percentage) to 8 per cent. Repo rate is the rate at which the RBI lends to banks.

Nevertheless, interest rates in India are much lower than they actually should be. Look at the accompanying graph. The red line is the interest rate at which the government of India manages to raise money (or what is referred to as the average cost of public debt). The green line is the average rate of consumer price inflation (CPI).

As is very clear from the graph, the government of India since 2007-2008 has been able to raise money at a much lower rate of interest than the prevailing inflation. This means it has been paying what economists like to call a negative real rate of interest.

How has the government of India managed to raise money at less than the rate of inflation for almost seven years now? The answer lies in the fact that we are a financially repressed nation. Banks are forced to invest ₹23 out of every ₹100 they raise as a deposit, in government bonds. This is technically referred to as the statutory liquidity ratio (SLR).

As the recently released Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework points out "Large government market borrowing has been supported by regulatory prescriptions under which most financial institutions in India, including banks, are statutorily required to invest a certain portion of their specified liabilities in government securities and/or maintain a statutory liquidity ratio (SLR)."

This ensures that come what may there is always a demand for government bonds. "The SLR prescription provides a captive market for government securities and helps to artificially suppress the cost of borrowing for the Government, dampening the transmission of interest rate changes across the term structure," the Expert Committee report points out.

This has essentially led to a situation where the government can even get away with offering a negative real rate of interest on its bonds, as it has over the last few years. Take the case of the last one year. The highest return on the 10 year government of India bond has been 9.24 per cent, which was in August 2013. Consumer price inflation has constantly been higher or around 10 per cent.

The rate of return on government bonds becomes the benchmark for deposits raised by banks. And if the government can raise money at a rate below the rate of inflation, banks can't be far behind. Hence, the interest offered on fixed deposits by banks has also been lower than the rate of inflation over the last few years. This led to Indians buying gold, in the hope of earning a rate of return higher than the rate of inflation. Ultimately, this led to a huge current account deficit and a host of other problems.

A bond market which is allowed to function reasonably independently can discipline the government. When the government is borrowing more than it should, the bond market investors can get out of government bonds by selling them. This will lead to bond prices falling. Even when bond prices fall, the interest paid on them continues to remain the same. Hence, the actual return on those bonds goes up. Or as the bond market investors like to put it, the yields increase.

In this scenario, when the government issues new bonds, it will have to match the rate of interest on these bonds, with the yields on the bonds already trading in the market. Hence, it will have to pay a higher rate of interest. This disciplines the government to some extent. In India, this does not happen, primarily because banks need to maintain a certain percentage of their deposits in government bonds.

So what should be the actual rate of interest that the government of India should be paying? There is a quick and dirty way to work that out. A bond market investor essentially looks at three things: What is the expected rate of economic growth? What is the expected rate of inflation? What is the risk premium that needs to be priced in? He then adds up these numbers to come up with the rate of return that a government bond should be offering.

In India's case, economists and other experts expect the country to grow at the rate of around 5-6 per cent. The rate of inflation is currently at 10 per cent and even the most optimistic forecasts do not expect it to go below 8 per cent. A risk premium of 2 per cent can be factored in. Hence, even with the most optimistic numbers (i.e. high growth and low inflation), the Indian government needs to pay an interest of around 16 per cent (6 per cent growth + 8 per cent inflation + 2 per cent risk premium).

What is it currently paying? As I write this on March 12, the return on the 10 year government of India bond currently stands at around 8.75 per cent. The Expert Committee report referred to earlier suggests that the "SLR should be reduced" in the days to come. But that is easier said than done. James Carville, a close advisor to Bill Clinton, when he was the American President, once said; "I used to think if there was reincarnation, I wanted to come back as the president or the pope or a .400 baseball hitter. But now I want to come back as the bond market. You can intimidate everybody."

He wouldn't have wished that if he was an Indian simply because the government does not allow the bond market in India to work.

Vivek Kaul is the author of 'Easy Money'. He tweets @kaul_vivek.

This column appeared in the April 2014 issue of Wealth Insight.