Borrowing Bad: Yield curve a public good, or best left to the market?

By NR Bhusnurmath

A notable omission in RBI Governor Shaktikanta Das’ latest monetary policy statement was the absence of any reference to the yield curve as a “public good”. Given that both the grant curve and his representative in charge of the governor monetary policy, Michael Patra, had repeatedly emphasized the ‘public good’ character of the yield curve in the past, the silence this time round was a bit puzzling. So, what explains the silence? Is the yield curve no longer a ‘public good’? More importantly, how critical is the yield curve, rather a ‘good yield curve’, for rapid economic growth? The issue is worth probing a little deeper. Two questions arise. One, what is a ‘public good’; does the yield curve fit the definition of a ‘public good’? And two, does elevating the yield curve to the status of a ‘public good’ help economic growth?

The term ‘public good’ is defined in economics as ‘a commodity or service that is provided without profit to all members of a society, either by the government or by a private individual or organisation’. Another defining characteristic is that consumption by one individual does not in any way impair consumption by another; the classic example being the air we breathe, not in any way reducing the air available to another. That is, as far as textbook economics is concerned.
The ‘Oxford Languages’ also defines ‘public good’ more loosely to mean something that is good for the public. Presumably, it is in the latter sense that the RBI has been referring to the yield curve as a ‘public good’. In fact, the term was used as far back as May 2007 when the central bank discussed the G Sec (government securities) yield curve in its Report on Currency and Finance 2005-06 (May 31, 2007, Box V.1 Role of Government Securities Yield Curve as a Public Good). The report went on to state that ‘the fact that the yield curve acts as a public good enjoins upon all participants, in particular the regulators, the responsibility of ensuring that it is free from any undesirable and manipulative influence, as this would lead to a loss in its incorrect informational value and result in market inefficiency brought about by pricing of other financial instruments.’

Unfortunately, the RBI’s own actions over the past few months have often been contrary to its advice in the report quoted above. The reason is RBI’s multiple roles—in particular, the role of debt manager to the government and monetary authority—are often in conflict with each other. Post-Covid, RBI put its role as debt manager on the front burner, relegating its monetary authority role to the background. According, it saw facilitating government borrowing at a low rate of interest as its foremost duty. Towards this end, RBI repeatedly primed the market to ensure successful completion (read, at the lowest possible cost) of auctions of government securities.

In the process, far from allowing the free play of market forces and allowing interest rates to be determined by demand and supply, RBI often intervened to prevent rates from rising beyond its comfort level. Free-market enthusiasts may well accuse the bank of manipulating G-Sec auctions, given whenever bidders in G-Secs seek higher yields, RBI has been simply rejecting the bids. The recent being on the rejection of bids to the tune of `15.53 billion in the 10-year GoI bonds auction on 13 April 2022.

Non-acceptance of bids in primary auctions goes against the very grain of the move towards the auction-driven price discovery process that was a hallmark of the reform process of the 1990s. Whether such manipulations can be considered as good for the public is debatable. That is not all. Through a series of what it calls ‘Operation Twist’—typically, selling and simultaneously buying securities of different securities—RBI has been trying to re-shape the G-sec yield curve. This might have been considered a legitimate central bank activity but for the fact that the sale and purchase of the securities in question is, once again, not done at market-determined rates but at ‘artificially’ derived rates.

The history of financial markets has, time and again, proved that ignoring market forces is unwise and often proves disastrous in the long run. In the instant case, RBI’s attempts to keep the yield on 10-year G-Secs at the 6% level had to be finally given up in the face of the market’s determination not to be brow-beaten into submission beyond a point.

Now to the second point. It has been argued that a ‘good’ yield curve (upward sloping) is in the interests of the public good as it facilitates economic growth. Is this borne out by fact? Theories on the relationship between bond yields and growth indicate that, on the one hand, current interest rates contain information about expected economic growth. On the other, expectations of economic growth influence bond yields. Studies in developed indicate lower precedent bond yields economic growth as lower bond yields mean lower cost of funds for investors, encouraging investment and thereby, economic growth.

The relationship between yield curves and economic growth is more complicated. An overwhelming body of research suggests that while an upward-sloping yield curve indicates a growing economy, the shape per se is not a determining factor. At best, an efficient bond market that is not subject to intervention by the monetary authority could predict economic growth or recession, nothing more. Recent experience, both in the US (where the yield curve has periodically inverted) and in India, too, bears this out.

Clearly, RBI’s efforts to manipulate the bond market to ensure a ‘normal’ yield curve have failed to achieve the desired objective. For a variety of reasons, the corporate bond market in India is under-developed. We remain a bank-driven economy. Bond yields have little to do with the cost of debt capital for large companies and are unlikely to influence their investment decisions and, hence, economic growth. Hopefully, this learning will inform RBI’s actions in the future.

The author is Adjunct professor, IMT Ghaziabad


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