Term Premia Debate: RBI’s Michael Patra Counters JR Varma’s View

The “term premia” is an esoteric concept that generates much debate across bond markets. Particularly across Indian bonds.

Defined as the difference between short-term and long-term interest rates, the term premia can hide a number of messages. A wide-term premia may signal economic expansion, the risk of inflation or uncertainty. A more narrow-term premia may signal relative stagnation or even a recession.

In India, the term premia has remained wide for at least the last few years, leading to much head-scratching on who is to blame and what its implications are.

The additional interest sought by investors to hold longer-term bonds over shorter-term debt widened further after the Covid-19 crisis hit. As the central bank cut rates sharply and flooded the system with liquidity, short-term rates plunged but longer-term rates, reflected in the yield on the benchmark 10-year government bond, didn’t fall as much.

Between July 2019 and August 2020, the term premium, as measured by the gap between the policy repo rate and the 10-year bond yield moved up by 150 basis points to 215 basis points. It currently stands at 190 basis points, with the repo rate at 4% and the 10-year yield at 5.90%.

But why?

The JR Varma View

Varma laid the blame for India’s steep yield curve firmly on the doors of the Monetary Policy Committee, according to minutes of the last MPC meeting. If the market believed the committee’s view on inflation and, hence, its accommodative stance on monetary policy, why would investors demand much higher interest rates for holding long term debt, he argued.

“One of the hallmarks of a credible inflation targeting regime is a substantial compression of the inflation risk premium. If the market expects inflation to average close to the target rate of inflation, then, by definition, inflation risk is low and consequently the inflation risk premium should also be very small,” Varma wrote in the minutes of the MPC meet. “What remains is essentially the liquidity risk premium which cannot explain the extraordinary steepness of the Indian yield curve.”

Varma dissented on the wording of the committee’s forward guidance at the last MPC meet. The guidance said that the MPC “decided to continue with the accommodative stance as long as necessary—at least during the current financial year and into the next financial year...”

“Just as the brakes allow the car to travel faster, the MPC’s guidance will be more effective if it works alongside and not in conflict with its inflation fighting resolve,” said Varma, adding that he preferred to use the word “expects” instead of “decided” in the forward guidance.

The Michael Patra Counter

RBI deputy governor Michael Patra, in a co-authored article published in the central bank’s November bulletin, took a different view, explaining that the factors driving term premia are “complex and constantly shifting.”

Patra, in the article co-authored with Harendra Behera and Joice John, laid down the correlation between different factors and term premia based on data between 2006 and 2020.

Their analysis showed that the correlation of term premia with realised inflation is moderate at 0.3.

The correlation of term premia with supply of government bonds matched that of inflation. Further, the correlation of term premia in the domestic bond markets has the highest correlation of 0.56 with global policy uncertainty in the period after 2012. “This indicates a growing sensitivity of India’s bond market term premium to global spillovers,” the analysis said.

The closest association of the term premium is with liquidity conditions represented by the net position under the RBI’s liquidity adjustment facility, it added.

In detailing these correlation, Patra sought to counter Varma’s view that lack of credibility on inflation is keeping long term yields high.

He also highlighted that the term premium has widened sizeably across all countries, both emerging and advanced in the aftermath of the Covid-19 crisis.

The bond markets evince extreme views, wrote the authors. “What one stands for depends on where one sits.”

The Implications

Varma in his minutes had argued that bringing down long-term rates is important for investment in the economy, and to prevent undue appreciation in the Indian currency.

“A significant part of the easing of policy rates is not being transmitted to longer term rates that form the benchmark for corporate borrowing and investment decisions,” Varma wrote in the minutes. “Excessive long-term rates exacerbate the collapse of investments in the economy.”

While Patra didn’t counter that view, he did seem to question the efficacy of a policy focus on term premia.

“With interest rates at or the near zero lower bound in several advanced economies, whether real or nominal, monetary policy that seeks to compress the term premium and influence the long-term interest rates more directly takes a step into the unknown,” he wrote, adding that outcome of such polices remains uncertain.