Price Discovery in Indian Government Securities Market, Monetary Management and the Cost of Government Borrowing

Over 2017-18 there was a sharp rise in Indian government securities (G-Secs) interest rates unrelated to fundamentals. Examining each of the standard explanatory variables shows them to be inadequate to account for the rise in bond yields in this period. Turning to aspects of Indian structure the reason is found to be the narrow focus of monetary operating procedures, with excessive reliance on making up liquidity shortfalls with short-term liquidity, which was inadequate given large exogenous durable liquidity shocks including foreign inflows. The composition of liquidity, share of reserve money and its sources all matter. Open market operations (OMOs) have a significant impact on yields. Large foreign debt inflows induce OMOs sales as G-Secs are swapped for foreign securities to sterilize the effect of inflows on the money supply. G-Secs yields are then found to rise.