Bonds. Economic laws don’t always hold

The rudimentary law of supply and demand mentioned in textbooks has suddenly run into ambiguity in the Indian context. Therefore, the reasoning of higher demand leading to higher price or higher supply bringing down price is passé. Also, lower price does not necessarily lead to higher demand which should normally be the case. Let’s see how these violations of economic laws have taken place this year.

First look at the G-Sec rate. The 10-year paper has now crossed the 6.50 per cent mark and the history in the current financial year has been that it has crept upwards, never relenting, notwithstanding the efforts of the RBI to keep liquidity in a surplus position all the time. The surplus is to the extent of ₹6-8 lakh crore on a daily basis. This has been done by inducing funds through G-Sec Acquisition Programme (which has been stopped now), besides the surpluses generated within the system. The bond yields should ideally have come down. In fact, some auctions have either devolved on PDs (primary dealers) or been withdrawn by the RBI when the market did not accept a lower rate. Therefore, the law of supply did not work.

The reason is that the market expected a higher return on two counts. The first is that inflation has been rising and there are expectations that it will continue to be in the 5-6 per cent range this year till March. Therefore, the market has started looking at real interest rates. The other is the size of the government borrowing programme or rather the expectation of it exceeding the budgeted ₹12-lakh crore.

While the government has announced new expenditures, the indication given is that there will be no excess borrowing which is hard to accept even though tax revenue has been buoyant. Disinvestment is still in a state of flux and to think that around ₹1.6-lakh crore can be mobilised in the next three months sounds difficult. Therefore, the market is demanding higher yields from the auctions.

Lending rates

Second, as the RBI has maintained the repo rate at 4 per cent notwithstanding the rising inflation syndrome on grounds of growth being the driving factor, banks have lowered their lending rates in general. On a point-to-point basis the weighted average lending rate on fresh loans for all banks came down from 8.07 per cent in April to 7.98 per cent in November, though there have been variations in both the directions during the year. But the weighted average rate on outstanding loans came down continuously from 9.10 per cent to 8.91 per cent during this period.

Therefore, loans were cheaper. Yet increase in credit was just 3.3 per cent over March (1.7 per cent last year) and 7.3 per cent on a year-on-year basis. Quite clearly there is less demand for credit and hence price is not a decisive factor. In fact, today there is a rather absurd situation of some banks giving home loans at 6.40 per cent which is even lower than the rate at which the government borrows.

As of November, growth in credit to manufacturing was negative, being driven by large industry, while that in services was just 0.8 per cent. Agriculture and retail lending had enabled this minimal growth. Here the surplus capacity in industry has come in the way of demand for credit.

Third, while we have had the advantage of having a good kharif harvest this time, food inflation remains the Achilles heel. Prices of edible oils and as well as horticulture products have moved up quite menacingly, upsetting the calculations of the RBI. Further, even core inflation has moved up amid stagnant demand. This too calls for an explanation.

While overall kharif crop has been good, India imports 60 per cent of its edible oil requirements which in turn means that inflation gets imported when global prices increase. The monsoon withdrawal was later than usual — this has become a worrisome pattern in the last few years — which in turn has increased the prices of vegetables in particular. Therefore, steady growth in agriculture has led to spikes in inflation due to a couple of categories of products.

In the case of the so-called core products, which is non-food and non-fuel, the picture is different. Higher raw material costs due to an increase in global commodity prices have pushed up retail inflation of consumer, personal care and pharma products. Also, services like healthcare, education and entertainment have become more expensive.

Companies have adjusted their prices to retain solvency at a time when restrictions have been put on their operational capacity for entertainment or tourism. In the case of healthcare, it is a case of the hospitals leveraging a situation where there has been a sharp rise in demand which has led to prices being pushed up even though costs may not have changed to the same extent. Therefore, commodity and service price inflation has been more due to supply side factors than demand.

Last, the currency too has been quite whimsical. Normally textbooks say that the exchange rate is the result of demand and supply of dollars. During the year so far, the forex reserves of the country increased by around $58 billion. This should normally have led to rupee appreciation. But the dollar rate has fallen from ₹72.5-73 in April to ₹74-75 by December. This may be explained by the global factor where a stronger dollar versus the euro caused all currencies to slide which included the rupee.

Deposit rates

On the other side, if one looks at the balance sheets of banks, the picture on deposits is interesting. The weighted average deposit rate on outstanding deposits has come down from 5.26 per cent to 5.04 per cent. Here it is a situation of banks lowering the deposit rate to ensure that deposits do not increase as they have a negative carry of 165 basis points when invested in the reverse repo window.

Deposit growth has slowed down to 5 per cent from 6.7 per cent last year (as of December 17). Here the banks may be better off because the flow of deposits has slowed down. Households have gravitated to alternative avenues like mutual funds, stock coins and cryptocurrency. This can be a worry going forward for the system as higher risk is taken by individuals.

Therefore, the markets seem to be no longer guided by the forces of demand and supply; extraneous factors have guided the prices. This will be the way going forward too. Hence, we cannot assume that the demand-supply forces will drive prices. Welcome to the new market economics.

The writer is Chief Economist, Bank of Baroda. Views are personal