Government bonds in recent times have largely been driven by expectations of a pause in the Reserve Bank of India's rate-hike cycle and speculation whether the central bank would continue or halt its open-market operations (OMO) to buy bonds to alleviate pressure on systemic liquidity.
During the last few days of December 2011, a slowdown in the Indian economy and poor tax collection had led to fears the government's fiscal deficit would overshoot its 4.5%-of-GDP target by a significant margin.
This coupled with a sharp rise in fiscal and revenue deficits during the April-November period converted the market's worst nightmare--further increase in borrowing--into a reality.
On the last day of December 2011, the RBI said that the government would borrow Rs 400 billion over and above Rs 4.7 trillion targeted for the financial year. As expected, sentiment was severely dented.
But contrary to the expectation of bond prices falling sharply after the increase in government borrowing, they instead surged sharply on the first day of the year 2012, thereby commencing the year on an optimistic note.
Sentiment improved as the economic slowdown and falling inflation numbers fanned hope the central bank of would pause its rate-hike cycle. Toward the start of the month, comments from RBI Governor Duvvuri Subbarao and Chairman of Economic Advisory Council to the Prime Minister C Rangarajan hinting at monetary-policy easing set the tone.
Also, the continuation of OMO--started by RBI in November to diffuse pressure in systemic liquidity--supported bond prices. The impact of increase in government borrowing had been largely offset by regular bond purchases in the recent months.
RBI Deputy Governor Subir Gokarn also commented that the central bank prefers OMO as its liquidity management tool over a CRR cut.
Government bond prices witnessed almost a secular uptrend for the larger part of the month. Owing to the liquidity crunch, the RBI, in its quarterly monetary policy review on January 24, 2012, cut CRR, for the first time in almost two years by 50 basis points.
Doubts whether the central bank would further continue with OMO following the CRR cut were laid to rest after it announced further bond purchases.
Aggressive buying by foreign banks at the beginning of their financial year also helped.
Except for a three-month period, the yields on government bonds fell on all other tenures as apparent from the yield curve. The yield in the three-month segment rose by 7 bps while the yield on 10-year benchmark bond fell sharply by 29 bps to 8.27% from 8.56% at the end of the previous month.
The 50 bps cut in the CRR infused around Rs 320 billion into the banking system, which was widely believed to be inadequate to address the severe strain on liquidity. Though the CRR cut relieved pressure on liquidity slightly, the situation was expected to worsen going forward because of the credit growth and state polls.
In fact, despite the CRR cut, the borrowing from RBI's repo tender under its Liquidity Adjustment Facility continued to be over Rs 1 trillion.
In the light of the same, the RBI later announced another bond purchase under OMO worth Rs 100 bn for the week ended February 3, 2012.
This improved market sentiment and helped bond prices move up. From mid-November till February 3, 2012, the RBI has bought bonds worth Rs 808.19 bn.