DETERMINANTS OF WEEKLY YIELDS ON

GOVERNMENT SECURITIES IN INDIA

By

DETERMINANTS OF WEEKLY YIELDS ON GOVERNMENT SECURITIES IN INDIA

Introduction

This paper examines the determinants of the Government yields in India using weekly data from April 2001 through March 2009. The analysis covers Treasury Bills with residual maturity of 15-91 days and Government securities of residual maturity one, five and ten years respectively. The empirical estimates show that a long-run relationship exists between each of these interest rates and the policy rate, rate of growth of money supply, inflation, interest rate spread, foreign interest rate and forward premium. At the same time, the empirical results also show that the relative importance of the determinants varies across the maturity spectrum. The normalized generalized variance decompositions suggest that the policy rate and the rate of growth of high powered money are less important in explaining the proportion of variation in longer term interest rates. The weight of the forward premium also diminishes as we move towards higher maturity interest rates. The inflation rate is also relatively less important in explaining variations in the 10-year rate. The yield spread, on the other hand, is more important in explaining the longer term rates. The results also show that a large proportion of the variation in the rates on the 5-year and 10-year government securities is attributed to the interest rate itself suggesting that the unexplained variation may be a result of cyclical factors that are relatively more important for longer term rates but are not captured by the yield spread and are omitted from the estimations due to the high frequency of data employed.

Interest Rates and Monetary Policy in India: Some Stylized Facts

The Indian financial system till the early 1990s was characterized by an administered structure of interest rates and restrictions on various market players, viz. banks, financial institutions, mutual funds, corporate entities. Under the erstwhile administered interest rate regime, the Reserve Bank of India fixed interest rates both on the assets and liability side (of the commercial banks) to ensure that the commercial banks had a reasonable spread. Government securities had a captive market resulting from the SLR requirement applicable to banks and similar statutory provisions governing investment of funds by financial institutions and insurance companies facilitated the floatation of debt at relatively low interest rates. Since lending and borrowing operations did not involve any interest rate risk, there was no real incentive for the market players to actively manage their assets and liabilities.

Moreover, in this era the public sector banks were not driven by the profit motive. There were also restrictions on the portfolio allocation in the form of specified targets. All these factors culminated in the lack of adequate volumes as a result of which the market lacked depth and liquidity. It may be mentioned here that alongside the developments in the Government securities market, the banking sector was also evolving to a significant extent in response to financial sector reforms initiated as a part of structural reforms encompassing trade, industry, investment and external ...