Relevance: GS III (Indian Economy) | Source: The Indian Express

1. What is the News?

• The profit percentage (called “Yield”) on India’s 10-year government bonds has suddenly shot up to nearly 7%.
• Why? The ongoing war in West Asia has made crude oil very expensive. This is causing a fear of high inflation (mehengai) in India, which is making financial markets panic.

2. The Basics

To understand this topic for Prelims, you just need to understand a simple seesaw rule:

• What is a Bond? It is simply a loan ticket. When the government needs money, they give you a “Bond” and you give them cash. They promise to pay you fixed interest every year.
• What is Bond Yield? It is the actual profit percentage a buyer makes if they buy an already-existing bond from the open market today.

The Golden Rule: Bond Prices and Bond Yields move in OPPOSITE directions.

• The Practical Example: * Imagine you buy a ₹100 government bond today that pays ₹5 interest every year (5% return).
  • Suddenly, inflation hits. To control it, the RBI announces that new bonds will now pay ₹7 interest.
  • Now, nobody wants your old ₹5 bond! To sell it to a friend, you have to offer a massive discount and sell it for just ₹80.
  • The Magic of Yield: Your friend spent only ₹80, but the government will still pay them that fixed ₹5 every year. Earning ₹5 on an ₹80 investment is a much higher profit percentage! Because the price fell, the yield went up.

3. Why are Yields Rising Right Now? 

If yields are rising today, it means bond prices are falling. Why are investors dumping bonds?

• Expensive Oil = High Inflation: India buys most of its oil from outside. Expensive oil makes transport costly, which makes everything from vegetables to clothes expensive in India.
• Expecting RBI Action: Investors are smart. They know that when inflation rises, the Reserve Bank of India (RBI) will soon hike interest rates to suck excess money out of the market.
• The Result: Because everyone expects new, high-interest bonds to come out soon, the prices of all current bonds are crashing today, pushing their yields up.

4. The Danger for the Indian Economy

If this global tension continues, India faces two big problems:

• Dollar Drain (Wider CAD): We will have to spend far more of our precious US Dollars to buy the same amount of expensive crude oil.
• The “Salary-Price” Loop: If everyday items stay expensive, workers will demand higher salaries to survive. Companies will pay them, but will increase the price of their products to cover the cost. This creates a dangerous, never-ending loop of inflation.

UPSC Value Box

With reference to the Indian economy and the government bond market, consider the following statements:

1. If the Reserve Bank of India (RBI) is expected to increase interest rates to fight inflation, the yield on existing government bonds generally goes up.
2. There is an inverse (opposite) relationship between the market price of a government bond and its yield.
3. Government securities (G-Secs) are issued by the Government of India but are managed and regulated by the Reserve Bank of India (RBI).

Which of the statements given above is/are correct?

(a) 1 and 2 only

(b) 2 and 3 only

(c) 1 and 3 only

(d) 1, 2 and 3

Correct Answer: (d)