India’s truce with bond traders tested as federal authorities borrow to reduce shortfall in tax revenue

The Reserve Bank of India’s week-long truce with the bond market is in jeopardy as it heads into a debt auction Friday after Prime Minister Narendra Modi’s government ramped up borrowing.

Federal authorities will raise an extra 1.1 trillion rupees ($15 billion) on behalf of the states to help with a shortfall in tax revenue, the finance ministry said late Thursday. This will be done via sales of three- and five-year bonds, according to the central bank.

Shorter-maturity bonds slid from the market open, with the five-year yield jumping as much as 12 basis points to 5.29%. The benchmark 10-year yield was up three basis points at 5.93% at 10:14 a.m. in Mumbai.

The announcement of new supply comes just a week after Governor Shaktikanta Das managed to damp tension with traders by doubling the size of open-market bond purchases and asking them to consider their “shared responsibility” for maintaining a stable market.

The moral suasion and promise of more buying had pushed the benchmark 10-year rate a comfortable 10 basis points below 6% before Thursday’s surprise increase in borrowing. This is a level traders see the RBI trying to defend, but the job will become difficult with more bonds coming to market amid a spike in consumer prices.

“Fiscal slippage or stickier-than-projected inflation further down the road could once again incite challenges,” Vishnu Varathan, head of economics and strategy at Mizuho Bank Ltd. in Singapore, said before the news on Thursday. “Expectations for significant pullback in yields may be disappointed.”

Last Friday’s debt auction went off without a hitch after Das ratcheted up his rhetoric and boosted the size of individual open-market bond purchases to 200 billion rupees. Traders had balked at the low yields on offer before that, forcing underwriters to rescue four of the previous seven sales.

India’s Playbook

The RBI’s approach to managing yields stands in stark contrast to the clearly defined bond-buying policies of its peers in much of Asia and around the world, leaving investors with more uncertainty.

It doesn’t have an explicit yield target like the Bank of Japan, or a quantitative purchase goal like the Reserve Bank of New Zealand. Nor does it have a set calendar for purchases like the Bank of Korea.

Instead it has tried to ensure markets have ample liquidity, while relying on ad hoc “twist” operations — simultaneous purchases and sales of bonds of different maturities — along with discreet purchases and outright OMOs.

Also setting the RBI apart is its struggle to lower inflation at a time when many other central banks are battling to rekindle price gains.

After seeing price gains significantly overshoot its targeted 2%-6% range, the central bank is now telling investors they can look through the latest bout of inflation.

While consumer price gains rose to an eight-month high of 7.34% in September from a year earlier, they will ease to 5.4% in last three months of this year, and drop to 4.5% in the following quarter, the RBI said last week.

Inflation Risk

“But what happens if it doesn’t?” said Rajeswari Sengupta, assistant professor at Indira Gandhi Institute of Development Research in Mumbai. “Would it just allow inflation to continue, without taking action to bring it down to acceptable levels? This wasn’t clear from the statement. Either way, the RBI’s credibility would be severely dented.”

Indian consumers appear even more concerned that high prices will persist, with the median inflation expectation of households over a one-year period sitting at 10.3%.

Worries over a spending blowout also continue to show up in the wide gap between the central bank’s short-term repurchase rate and 10-year yields.

“The Das put will keep getting tested and the market will now look forward to weekly OMOs of 200 billion rupees if the 10-year bond yields have to remain below 6%,” said Arvind Chari, head of fixed income and alternatives at Quantum Advisors Pvt Ltd. in Mumbai.

Friday’s debt auction bidding is scheduled between 10:30 a.m. and 11:30 a.m. in Mumbai. India selling 80 billion rupees of 5.22% 2025 notes, 120 billion rupees of of 6.19% 2034 bonds and 80 billion rupees of 7.16% 2050 debt.

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