Infrastructure

The link between US bond yields, Indian stock markets, GDP and GVA growth rates

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Dear Readers,

Last week was very eventful for the Indian economy.

Possibly the most influential development, especially for the Indian stock markets, was the sharp spike in the yields that one earns from United States government bonds.

The calculation of bond yields is not a straightforward thing. But here’s a quick explanation.

Across the world, governments sell bonds to raise money to meet their expenditure. These bonds have a selling price and a fixed coupon rate (or the absolute amount of money that you will earn). So if a 10-year government bond (called Treasuries in the US, Gilts in Britain and G-Secs or government securities in India) is priced at $100 and the coupon rate is $5 then it simply means that if you buy such a bond from the government for $100 today, it will pay you $5 each year and return you $100 at the end of the 10 years.

In this example, the “yield” or the annual rate of return that you enjoy from the US bond is 5%. But, this yield can change if the selling price of the bond changes.

Imagine a scenario where, at the start of the second year, investors turn cagey about the prospects of the broader economy or the private firms. In such a case many of them may decide to invest in government bonds because that is the safest investment in town. Under the circumstances, the demand for government bonds will rise and so will their prices. Suppose the price of the same 10-year bond rises by a dollar to $101.

What happens to this bond’s yield?

Since the coupon rate is still $5, the effective return — on an investment of $101 — that bondholders will get at the end of the second year will be only $4. That implies a yield of 3.96% — a distinct fall from the 5% bondholders earned in the first year.

Since government bonds are the safest investments, their yields tend to be the benchmark for interest rates in the economy as well as investor confidence. If investors find it more lucrative to lend money to businesses, they move away from government bonds, which results in a fall in bond prices and an increase in yields. If they are concerned about the state of the economy, they rush to buy bonds and thus yields fall.

Now, as the Covid-19 vaccines are being rolled out in the US and economic activity (helped generously by government spending) gathers pace, investors are moving away from government bonds — thus spiking the bond yields.

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Apart from being the benchmark domestically, the US bond yields are very influential globally as well. That’s because they attract funds from investors across the world. Investing in US treasuries is one of the safest bets and if such bond yields are rising then they become an even more attractive proposition. Higher yields in the US also signal the US central bank — the Fed — might raise interest rates to contain inflation, which will rise as economic growth takes off in that country. As a result, many global investors pull out money from emerging economies such as India, where economic recovery is still a tad iffy, and either invest in US bonds or the broader economy. This reverse flow explains why India’s domestic stock markets suffered in the last few days.

In fact, yields of Indian G-secs have also risen in line with US bond yields. In essence, this means investors find lending to the Indian government a better alternative than lending to the Indian firms via the stock markets.

This links back to the other big story of the past week — the release of the so-called Second Revised Estimates (SAE) of national income for the current financial year by the Ministry of Statistics and Programme Implementation (MoSPI).

In the First Advance Estimates, released on January 7, the government expected India’s GDP to contract by 7.7% in the current financial year. The SAE released on February 26 peg this contraction at 8%.

This cannot be great news for the economy.

As ExplainSpeaking highlighted when the First Advance Estimates were released, a contraction by 7.7% meant that India’s per capita GDP, per capita private consumption and the level of investments in the economy — all were expected to fall to levels last seen in 2016-17 or earlier.

At minus 8%, most of these key metrics have either worsened or, in case they have improved, they haven’t done so substantially enough. For instance, according to the FAE, the per capita GDP in 2020-21 was estimated to be Rs 99,155. According to the SAE, this number has fallen further to Rs 98,928 — that’s a fall of Rs 227 per head across each of 1.36 billion Indians.

However, there was a silver lining in the national income data — the growth rate of Gross Value Added (GVA).

Typically, it makes sense to look at the GDP, which maps national income from the point of view of what was the total amount of money spent in an economy, for comparing the full-year performance of an economy.

But there is another way to look at the economy’s performance — that is to look at Gross Value Added (GVA). Simply put, the GVA captures the value added (in money terms) by economic agents in each sector of the economy.

The GVA is more relevant when one tries to map how the domestic economy is changing from one quarter to another. In fact, during the year, it is GVA data that is made available first — not the GDP. The GDP is arrived at by taking the GVA number, adding all the taxes earned by the government and subtracting all the subsidies provided by the government.

This implies that for the same level of GVA in an economy, the GDP could alter just because the government earned more money from its taxes or spent more on subsidies.

In other words, if one wants to know the true state of India’s economic revival, one should focus on the GVA. The table alongside provides both GVA and GDP revisions between the FAE and the SAE.

Growth Rate of First Advance Estimates (FAE) in January

Second Advance Estimate (SAE) in February

Total GDP —7.7% —8.0%
Total GVA —7.2% —6.5%
Agriculture GVA 3.40% 3.00%
Industry GVA —8.5% —7.4%
Services GVA —9.2% —8.4%

Table: GVA growth rate points to economic recovery (Source: MoSPI)

It is clear that even though the GDP growth rate has been revised down, the GVA growth rate has been revised up. While both the industry and the services sectors are expected to contract this year, the pace of contraction is lower than what was expected in January.

As India embarks on a new financial year, that is heartening news as it points to an economic recovery even though the GDP growth rate has worsened.

Take care!

Udit

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