Eye of Siva

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Why are bond yields so low in India?

Bond yields in India are too low. That might seem strange for a country where the 10-year benchmark bond yields close to 8.2%. But a comparison with deposit rates shows that in recent years, the long bond yield has been lower than bank deposit rates. The chart below shows the 1-year deposit rate at the State Bank of India, India’s largest bank relative to the yield on government bonds. Banks in India are required to maintain 23% of their deposit base in government bonds. This creates a natural demand for bonds. However for years banks have been maintaining bond holdings well in excess of the minimum requirement.

SBI deposit rate vs Bond Yield

So that is not it. It is even stranger when we consider the fact that the last couple of years has seen high inflation and very tight liquidity conditions that have forced deposit rates higher. Indeed bond yields are well below the rate of inflation. One explanation is that the tight liquidity condition itself creates a demand for bonds. For its own reasons, the Reserve Bank of India provides liquidity to banks primarily against government bonds only. That is to say, if a bank found itself needing emergency cash, the only source was to borrow money from the RBI with excess bonds as collateral (a process known as repo). RBI adds money under repo overnight. The amounts under repo in recent years have been large possibly adding to this source of demand.


In the chart above, a negative figure indicates borrowing from the RBI and positive figure indicates liquidity absorption or lending to RBI. As may be seen, since mid-2010 banks have been borrowing large quantities of money from RBI. This creates an interesting conundrum: if banks have to borrow everyday to fund themselves, why not just sell the bond (it is excess over the minimum after all).

Here there is another twist. The RBI lending rate (the repo rate) is lower than the bond yield. Thus a bank takes a deposit and say, buys a bond at 8%. It could then pawn it to the RBI at 7.25% getting its money back and earning a clean spread of 0.75%. The money then can be used to lend to a company at higher interest rates. This effectively lowers the deposit cost (or effectively increases the yield on the loan, either way).

This works as long as the RBI is willing to lend unlimited amounts of money against the excess bonds. Last week the RBI raised one key rate that it uses to lend money by 2 percentage points from 8.25% to 10.25%. Earlier this week, RBI limited the amount banks can borrow at 7.25% using this technique to 0.5% of the deposit base. The banking system in total holds far more than that in excess bonds. Naturally bond yields have spiked.

Currently the banks still believe that the limits imposed and the increase in interest rate is temporary. If this holds for an extended period, we should expect yields to rise above deposit rates. It is another question if that happens through a further rise in bond yields or a sharp fall in deposit rates. The latter would occur if there is a fall in loan demand in response to the rate increases.

Post Script

Note too that another reason for the bond yield to remain low is the sustained bond buying programme of the RBI in recent years. RBI has been monetizing large amounts of the government’s deficit through what are called open market operations to buy bonds from banks. RBI’s purchases could have kept prices high and yields low. By the way, this could have contributed to high inflation in recent years. Note the periods of tight liquidity in 2008-09 following the financial crisis and again post-2010. The RBI’s open market purchases have gone hand-in-hand with the need for financing – both restricted to government bonds. These periods are the periods where the spread between deposit rates and bond yields have been the highest.

rbiomoSource of first two charts: Bloomberg. Source of data for the last chart: Reserve Bank of India.



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