A Macroeconomic View of the Shape of India's Sovereign Yield Curve Michael Debabrata Patra, Harendra Behera and Joice John; RBI Bulletin June 2021 ...
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ARtICLE
SUMMARY
A Macroeconomic View of the Shape of India's Sovereign Yield Curve
Michael Debabrata Patra, Harendra Behera and Joice John; RBI Bulletin June 2021
The sovereign yield curve has a special significance yield-only model is used as a benchmark to evaluate
for monetary policy in influencing a wide array of the gains in accuracy when augmenting it with
interest rates in the economy. The authors build on macroeconomic variables. The model is estimated
this idea by incorporating additional macro by using Bayesian methods which score over other
variables to capture open economy dynamics as time-series approaches in dealing with a large
well as RBI's liquidity and market borrowing number of parameters over relatively short periods.
strategies. Bayesian methods are applied to estimate The unobservables (latent variables) are filtered out
the model parameters as they are efficient in by using a multivariate Kalman filter.
dealing with unobserved variables. The results
The results show that benchmark estimates point to
indicate that the hybrid model predicts the
a steady softening of the level of the yield curve
observed yields well.
since 2018:Q4, which indicate that the yield curve
The estimation framework in this paper follows was shifting downwards coincident with the shift
the tradition of the dynamic latent factor approach in the monetary policy stance towards
augmented with macroeconomic variables accommodation. From Q1:2019-20, however, the
representing real activity, inflation, and the slope of the yield curve started rising, reflecting
monetary policy stance. The dynamic latent factor successive reductions in the policy rate even with a
yield-macro model for estimating the yield curve in neutral policy stance, which depressed short-term
India is based on liquidity conditions or LIQU, yields more than proportionately. From Q1:2020-
captured by the outstanding absorption/ injection 21, the slope of the yield curve started to ease with
under the RBI's liquidity adjustment facility (LAF) the deployment of unconventional monetary
as a proportion to banks' net demand and time policy instruments by RBI that resembled balance
liabilities. The government market borrowing sheet policies adopted by systemic central banks.
program is proxied by the market borrowing to
Synchronously, with both short-term and long-
market turnover ratio (GMB) and global
term yields softening, the curvature had increased,
uncertainty is represented by the Global Economic
reflecting the relative inflexibility of the
Monthly Newsletter June 2021
Policy Uncertainty index (GEPU). LIQU, GMB,
intermediate segment of the yield curve, which is
and GEPU are treated as exogenous variables. The
essentially populated by off-the-run securities. A
model is estimated for the period spanning the first
decline in the policy rate had an immediate positive
quarter of 2010 to the corresponding quarter of
impact on the slope of the yield curve as the impact
2021 on Indian government security yields of
of the policy rate change was swiftly and completely
maturities of 2 to 10 years. All data are sourced
transmitted to short-term maturities, causing the
from RBI's Database on Indian Economy (DBIE).
yield curve to become steeper. The results indicate
In addition, the authors include global factors,
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that the model predicted the observed yields well. It
liquidity conditions, and government market
also revealed that the level of the yield curve had
borrowing programs in the augmented model. This
7ARtICLE
SUMMARY
undergone a downward shift from the second and absent demand, central banks have to turn to
quarter of 2019, reflecting the impact of ultra- market-based channels of transmission to ensure
accommodative monetary policy on longer-term congenial financial conditions for the recovery. In
yields; however, there was a steepening of the yield such situations, the gilt yield, off which other
curve due to abundant liquidity depressing short- financial instruments are priced, becomes a
term interest rates and a pick-up in issuances of variable that is more important for monetary
ultra-long dated papers. policy than debt management, and hence,
macroeconomic conditions should be taken into
The authors also highlight the role of
account in the assessment of the level, slope, and
macroeconomic factors. The ebbing of infections
curvature of the yield curve. They emphasize that
between September 2020 and March 2021 had
monetary policy is a potent instrument for
fuelled hopes of the resumption of strong and
influencing the term structure of interest rates as
sustained growth. Inflation expectations also
policy rate changes tend to impact the slope of the
appeared to have set a floor to the evolution of
yield curve, while liquidity impacts the level as well
yields. Confronted with the interrupted
as the slope of the yield curve, rendering it a better
transmission, RBI engaged in large-scale open
instrument for managing the yield curve. The
market purchases of government bonds in the
authors underscore that managing inflation
secondary market, effectively taking the overload
expectations, through effective communication,
of pandemic-related security issuances by the
should be part of any strategy to manage the yield
government onto its balance sheet. Among other
curve since changes in inflation expectations can
macroeconomic determinants, global policy
counteract the monetary policy stance. These
uncertainty impacted the slope and curvature of
evolving yield curve dynamics suggest the scope for
the yield curve, signifying the rising exposure of
open market operations and the points on the yield
bond markets in India to global spillovers. Thus, in
curve to which they need to be targeted.
these extraordinary times, the developments in gilt
markets in India as well as in the rest of the world Source:
presented a term premium conundrum. https://www.rbi.org.in/Scripts/BS_ViewBulletin.a
spx?Id=20321
The authors conclude the research on the note that Monthly Newsletter June 2021
when the traditional channels of transmission of
monetary policy are frozen because of risk aversion
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8ARtICLE
SUMMARY
Fiscal Framework and Quality of Expenditure in India
Sangita Misra, Samir Ranjan Behera, Bichitrananda Seth and Saksham Sood;
RBI Bulletin June 2021
The COVID-19 pandemic necessitated an The authors use six indicators namely - revenue
overwhelming fiscal response from governments expenditure to capital outlay ratio; revenue deficit
across the world. In this research note, the authors to gross fiscal deficit; capital outlay to total
propose a few quantifiable indicators namely ratios expenditure; capital outlay to GDP; development
of revenue expenditure to capital outlay and expenditure to GDP; and committed expenditure
revenue deficit to gross fiscal deficit along with to GDP, (a composite indicator of the quality of
threshold levels for them that can be suitably expenditure) and employ principal component
blended into the fiscal fabric for a sustainable analysis (PCA), separately for the centre and the
growth trajectory. states. The indices reveal that there has been
deterioration in the quality of the centre's
Typically, fiscal rules aim at correcting distorted
expenditure, with some improvements observed
incentives and containing pressures to overspend
during the post-Fiscal Responsibility and Budget
to ensure fiscal responsibility and debt
Management Act (FRBM) high growth years. In the
sustainability. Cross-country experience reveal that
case of states, the 1990s'deterioration in quality of
rules set up in terms of headline fiscal balances tend
spending was not only arrested but also
to impart pro-cyclicality to fiscal policy, lowering
significantly improved during the pre-GFC high
the quality of fiscal spending, and reducing
growth period. The improvement stalled in 2009-
discretion in the hands of the government to
10 and there has been a general deterioration in the
respond to exogenous/uncertain shocks to
post-GFC period. The authors highlight that the
business cycles. It is in the context of the latter that
fiscal rules, when they were conceived, embedded
second-generation fiscal rules incorporated
features focusing on the quality of expenditure.
escape/buoyancy clauses and are defined in
The FRBM Act, 2003 sought to build in quality in
cyclically adjusted terms (rather than headline
the form of the prescription of a zero-revenue
fiscal balances) given their superior stabilization
deficit. However, it is found that the emphasis on
properties. Institutionalizing quality of
quality was compromised in the post-GFC period.
Monthly Newsletter June 2021
expenditure into fiscal rules is increasingly being
found in the emerging market economies (EME) Successful normalization of the fiscal stance is
experience in a refreshing departure from extant conditional upon an improvement in underlying
rules that generally target total spending. economic activity. The imperatives of large-scale
International comparison indicates government post-pandemic reconstruction warrant that fiscal
expenditure on human capital in India is way rectitude should not be achieved at the cost of the
behind BRICS and advanced nations. The authors quality of expenditure. The thrust of fiscal policy
thus highlight that a clear lesson for India from the stance on capital expenditure and infrastructure
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cross-country experience is to not compromise on creation, by both centre and states, marks the
the quality of public expenditure. definite intention of the government to improve
9ARtICLE
SUMMARY
the quality of expenditure. Accordingly, it may be repurposing and reprioritizing both revenues and
important to lay down a medium-term fiscal expenditures, fiscal authorities have shown that
framework with concrete measures and targets. they can extract 'bang for the buck' by (a) the public
Shoring up the quality of expenditure through a sector leading the private sector into unlocking
quantifiable matrix will help provide the necessary growth opportunities; (b) the public sector co-
checks and balances and should be integrated into exists with the private sector in entrepreneurial
the fiscal framework. A well-thought-out strategic partnership; and (c) the public sector stepping back
policy mix should protect programs with high to allow private enterprise to take the lead in
marginal social benefit, thus ensuring that the sunrise areas, coalescing into an across-the-board
intent to improve quality fructifies into desirable improvement in the quality of fiscal spend and
outcomes. A third threshold could be through a eventually in the quality of growth. The Union
floor to the capital outlay-GDP ratio or targeting a Budget 2021-22 takes a step in this direction by
particular rate of growth in capital outlay to arrest attempting to reshape the composition of spending
the moderation in its share in total expenditure. in favour of infrastructure, which is appropriate
from the point of view of India's requirement of an
The authors conclude that the way forward lies in
investment of US$ 1 trillion in the quest for a
setting out analytically the critical elements of a
world-class physical infrastructure.
post-pandemic fiscal framework for India that
blends quantitative dimensions of debt Source:
sustainability as traditionally defined with criteria https://www.rbi.org.in/Scripts/BS_ViewBulletin.a
that preserve and enrich the quality of expenditure spx?Id=20322
to secure the greatest common good. By strategic
Monthly Newsletter June 2021
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10ARtICLE
SUMMARY
Long Run Saving - Investment Relationship in India
Bichitrananda Seth, Kunal Priyadarshi and Avdhesh Kumar Shukla; RBI Occasional Papers
This paper revisits the Feldstein-Horioka puzzle for The results suggest a comparatively lower
the Indian economy. Martin Feldstein and Charles association between saving and investment in the
Horioka, in their seminal paper published in 1980, post- GFC period. This implies a relatively lower
raised crucial questions relating to how the world's use of foreign savings and a higher dependence on
supply of capital is internationally mobile, such as domestic savings. The slowdown in real fixed
whether capital flows among industrial countries investment in the post-GFC period was largely due
to equalise the yield to investors, or the saving that to private corporate investment. India's investment
originates in a country remain to be invested there, slowdown is a balance sheet related slowdown.
or the truth lies somewhere between these two Many companies have had to curtail their
extremes. Their empirical work gives a puzzling investments because their finances are stressed, as
result that domestic savings and investment within the investments made during the boom period have
a country are highly correlated. Their finding was not generated enough revenues to allow them to
contrary to the conventional wisdom. Feldstein service the debts that they have incurred. The
and Horioka argued that under perfect capital decline in domestic saving was led equally by
mobility, the association between domestic savings household and public sector saving. The fall in the
and investment should be negligible or non- former was on account of physical saving. The
existent since savings can move out of the domestic private corporate saving, on the other hand, has
market seeking higher returns from the global increased steadily.
market. This implies that a part of the investment
The authors consequently analyse the changes in
in a country can be financed by global funds. By
cross-country investment and saving after various
contrast, the saving-investment relationship is
crises and draw inferences to examine whether
expected to be strong for zero capital mobility since
India is an outlier in terms of a high correlation
savings must be invested domestically.
between saving and investment, save for a brief
The empirical analysis in the paper is based on period. Accordingly, they analysed movements in
annual data for the period 1955-56 to 2018-19 saving rate, investment rate and saving-investment
Monthly Newsletter June 2021
extracted from 'Handbook of Statistics on the gap of crisis-affected economies, starting from the
Indian Economy' published by the RBI. The Mexican peso crisis. The timing of crises and crisis-
nominal savings and investment figures are divided affected economies are decided based on a
by nominal GDP at market prices at 2011-12 base. literature survey. For ascertaining a change in
To ascertain the incremental impact of the changes saving and investment behaviour of crisis-affected
that took place during the post-global financial economies, the authors have compared their
crisis (GFC) period, the authors have undertaken a average saving and investment rates before and
separate analysis for the (sub-sample) period 1955- after the crises year. They have used a five-year
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56 to 2007-08, and then for the full sample. average of pre-crises and post-crises saving and
11ARtICLE
SUMMARY
investment rates for each affected economy. The empirical results in the paper thus confirm a
Accordingly, they have 21 economies with different long-run relationship between domestic savings
crisis episodes. and investment. A comparison of the long-run
coefficients for the full sample period (1955-56 to
It can be observed that after the crisis, investment
2018-19) with those for the sub-sample period
rate of all countries, except those of the USA (GFC),
(1955-56 to 2007-08) indicates a relatively higher
Indonesia and Turkey (after 2013), declined
degree of association between domestic savings and
significantly. Savings rate also declined after the
investment. This, in turn, suggests a reduced role of
crisis, though at a comparatively moderate pace
foreign saving in financing investment activity
than the decline in investment rate. In fact, many
after the global financial crisis of 2007-09. This
economies were able to increase their saving rate
largely reflects moderation in private corporate
after the crisis. The result of this asymmetric
investment rate in the post-global financial crisis
behaviour of economies gets reflected ultimately in
period. In conclusion, the authors opine that going
their saving-investment gap, which records a sharp
forward, as physical capital formation revives, it
decline in the post-crises period vis-à-vis pre-crises
should also be backed by a commensurate rise in
period. Out of 21 crisis-affected country episodes,
domestic savings for sustained long-run growth. At
only the USA (2007-08), Brazil (1994) and
the same time, it is important to enhance the
Indonesia (2013) recorded a higher saving-
efficiency of domestic financial system to improve
investment gap post-crisis, while all others
the allocation of resources to the most productive
recorded narrower gaps. This experience reinforces
sectors.
the role of frictions in global financial markets,
which manifest from time to time in crises, leading Source:
to a higher correlation between domestic saving https://rbi.org.in/Scripts/bs_viewcontent.aspx?Id
and investment rate. Thus, the observed saving- =4000
investment relationship in India is not an
exception.
Monthly Newsletter June 2021
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12ARtICLE
SUMMARY
Macroeconomic Implications of Bank Capital Regulations
Ranajoy Guha Neogi and Harendra Behera; RBI Occasional Papers
Research on the role of adequate bank capital in The authors verify the robustness of the results
ensuring financial stability and mitigating losses obtained by treating a different version of
from future crises had gained further traction at a aggregate CRAR series, based on the median of
global level in the post-subprime crisis period. In bank-level CRARs. The sensitivity of borrowing
this paper, the authors focus on the macro- cost to CRAR is found to be greater than the
financial implications of increased regulatory sensitivity of lending rate to CRAR as evident
capital requirements. They theoretically analyse from a steeper trend line for the former. Thus, an
and empirically examine the impact of increased increase in the capital position of banks helps
regulation-induced higher capital position of them to not only access funds at cheaper costs but
banks on credit flows under partial Modigliani- also increase credit as they reduce their lending
Miller offset (MM offset). rate. This implies that in a bank-level study, with
higher capitalization, the WACC shall always rise
The authors use a theoretical model and empirical
and the credit supply from the banks fall. This
estimates from a sign restricted vector
subdued and costlier credit supply brings down
autoregression (VAR) model to theoretically show
the GDP as the cost of production rises for the
the possibility of reduction in weighted average
non-financial firms. This result implies that bank
cost of capital (WACC) of the banks due to lower
capital reduces the WACC of banks and raises the
leverage, with higher Capital to Risk (weighted)
GDP growth rate making a free lunch situation as
Assets Ratio (CRAR), contributing to higher flow
it not only reduces the probability of crisis and the
of bank credit and the resultant rise in GDP
crisis contingent losses but also raises GDP for a
growth. In the empirical analysis, it is found that a
sufficiently high magnitude.
positive bank capital shock (i.e. higher capital
adequacy) can push the GDP growth up and For empirical estimation, the authors use
reduce risky lending. An aggregate measure of quarterly data of the relevant macro-financial
CRAR (a weighted average of bank-level CRARs) variables for the period 2009-10:Q1 to 2017-
is used to capture the effects of regulatory change 18:Q4. The variables used are real GDP, consumer
Monthly Newsletter June 2021
on system-level bank capital as a whole. It is found price index (CPI), policy repo rate, real non-food
that higher capital tends to lower the risk bank credit (RNFBC), spread (calculated by
premium and overall cost of liabilities of banks taking the difference between the weighted
while enhancing their capacity to undertake risky average lending rate and repo rate), and CRAR. It
lending. Regulatory CRAR is also found to work is found that a shock to CRAR captures a change
like a macro-prudential tool as a higher CRAR in regulatory CRAR that transmits to the banking
triggers loan portfolio reallocation in banks away sector. This ends up raising the equity (and equity
from unsecured high-risk loans towards secured to asset ratio) component in the liability side of
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and low-risk loans. the banks. Due to a regulatory capital shock,
CRAR increases. Higher CRAR, by improving
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SUMMARY
creditworthiness, reduces WACC and spread, and industry, which under increased regulatory capital
increases credit supply and thereby output. The requirement incentivizes banks to cut down on
positive effect of CRAR can outweigh the negative risky assets with higher weights.
effects (on credit due to costlier equity financing
The authors conclude on the note that the fall in
and the regulatory risk weights). A net increase in
the cost of capital reduces the lending spread and
credit supply would consequently let the niche
augments credit supply. Regulatory bank capital
firms reliant on bank credit expansion.
shock in the Indian context renders a positive
In terms of the macroeconomic impact of changes credit-led push to GDP growth by strengthening
in capital, the authors find that the CRAR increases the balance sheets of banks and the consequent
by about 9 basis points (bps) in response to one reduction of their overall cost of borrowings. This
standard deviation economy-wide bank capital idealistic situation indicates the benefits of
shock; and the effects remain for a substantial mitigating crisis through raised capital come with
period. The bank lending spread is found to decline the added fillip to GDP growth. The authors
noticeably and sustained over ten quarters possibly emphasize that these empirical results should be
because of the increase in credibility due to taken with the caveat that it cannot be generalized if
improvement in their balance sheets. The CRAR gets increased by a large amount and the
reduction in risk premium provides the banks empirical results obtained in this paper may not
access to a greater pool of funds at a cheaper price. hold under other contexts and for other countries.
As banks adjust their lending rate downward, it A statistically significant negative effect of bank
leads to higher credit growth. Thus, the real credit capital shock on credit and GDP growth may also
growth rate shoots up over four quarters and materialize. The authors present the further
consequently, the GDP growth rate remains identification of the exact transmission channel(s)
buoyant over six quarters. In this context, the of a bank capital shock impacting lending spread
authors highlight that the recent fall in the growth or credit supply as an area of future research.
of bank credit to the industry in India could be a
Source:
result of increased stressed assets in that sector and
https://rbi.org.in/Scripts/bs_viewcontent.aspx?Id
consequent apprehension of higher default. It
=3997 Monthly Newsletter June 2021
could also be due to higher risk weight on loans to CCIL
14ARtICLE
SUMMARY
State of the Economy
RBI Bulletin June 2021
The need to complement vaccines with ramping crore to be made available on tap for fresh bank
up investments is emphasized in this note. The lending of up to 3 years tenor at the repo rate for
speed and scale of vaccination against COVID-19 services adversely impacted by the pandemic such
is expected to shape the path of economic recovery as hotels and restaurants, tourism, aviation
which has the resilience and the fundamentals to ancillary services, and other contact-intensive
bounce back from the pandemic and unshackle it services. As an incentive, banks have been allowed
from pre-existing cyclical and structural to park amounts equivalent to their loan book
hindrances. The National Statistical Office (NSO) under the window as fixed-rate reverse repo with
revised India's real GDP for 2020-21, revealing a RBI and earn 3.75 percent as against the rate of
shallower contraction (-7.3 percent) than earlier 3.35 percent offered under the liquidity
estimated, with the brighter outcome for the adjustment facility (LAF). A special liquidity
fourth quarter (January-March 2021) turning out facility of `16000 crore at the policy repo rate was
to be the decisive swing factor. extended to the Small Industries Development
Bank of India (SIDBI) for on-lending to micro,
On June 4th, drawing on the decision of the
small and medium enterprises (MSMEs),
monetary policy committee (MPC) to continue
particularly smaller MSMEs and other businesses,
maintaining the policy rate at its all-time low of 4
including those in credit deficient and
percent (unchanged since May 2020) and also to
aspirational districts. The coverage of Resolution
continue with an accommodative stance as long as
Framework 2.0 announced on May 5, 2021, for
necessary, the Reserve Bank (RBI) announced
resolution of COVID-19 related stress among
another large purchase operation in June to
micro, small and medium enterprises (MSMEs) as
complete its asset purchase initiative G-SAP 1.0.
well as non-MSME small businesses and
Of the quantum of `40000 crore announced,
individuals (for business purposes) was expanded
`10000 crore was reserved for state development
by enhancing the maximum aggregate exposure
loans (SDLs) to compress their spreads over
threshold from `25 crore to `50 crore.
corresponding central government securities.
Monthly Newsletter June 2021
This is expected to work towards improving the A significant landmark that was quietly passed in
appetite for ultra-long central government early June was the level of foreign exchange
securities vis-à-vis SDLs, with the yields of the reserves crossing US$ 600 billion. With this
former becoming relatively attractive for buy-to- development, India is the 5th largest reserve
hold investors. A G-SAP 2.0 of `1.20 lakh crore holding country in the world, the 12th largest
was also announced for Q2:2021-22, coinciding foreign holder of US treasury securities, and the
with the peaking of the volume of issuances 10th largest in terms of gold reserves. Globally,
planned for the year. central banks view the surge in inflation as
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transitory and have talked down speculation
Expanding the financial safety net further, RBI
about dialing back their easy policy stance.
also announced a liquidity window of `15000
15ARtICLE
SUMMARY
The authors conclude on the note that the Indian September 2021, and around 113 crore more doses
economy continues to wrestle with the second wave are needed; accordingly, around 93 lakh
of the pandemic, though cautious optimism is vaccinations are required per day to achieve the
returning. In the current assessment, the second herd immunity. Going forward, the speed and scale
wave's toll is mainly in terms of the hit to domestic of vaccination will shape the path of recovery. The
demand. On the brighter side, several aspects of economy has the resilience and the fundamentals
aggregate supply conditions such as agriculture and to bounce back from the pandemic and unshackle
contactless services are holding up, while industrial it from pre-existing cyclical and structural
production and exports have surged amidst hindrances.
pandemic protocols. The Ministry of Finance
Source:
estimated that to achieve herd immunity and
https://www.rbi.org.in/Scripts/BS_ViewBulletin.a
regain the momentum of the economic recovery,
spx?Id=20320
the target population to be vaccinated is 70 crore by
Monthly Newsletter June 2021
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