The Hindu Business Line : Liquidity may tighten in bond market

Traders said that the bear trend was triggered by apprehensions over the Common Minimum Programme (CMP). Bankers said that the CMP raised questions on fiscal sustainability. Despite promises of the Government to bring down the revenue deficit to zero, current indications are that the deficit would move in the opposite direction on account of increase in subsidy components. Besides, the new Government has already halted divestment in public sector units. Consequently, all their funding requirements would have to be met directly in the form of budgetary support or through borrowings.

What has also started worrying bankers is the Government's waffling over passing on the increases in international oil prices. One banker said, "If this cost has to be underwritten by the Government, we can brace for higher interest rates."

Oil prices have remained above $40 per barrel. If product prices were not sufficiently increased with built in cross-subsidies, then the costs would have to be borne by the Budget.

Traders have taken a view that the Government's borrowings would face a substantial escalation. The Government till last year had preferred redemptions of all high-coupon securities or recalling some of them and substituting them with low coupons. The change in perception was one major reason for nervousness in the debt markets.

Further, traders were also prepared for a hike in interest rates in the US. Expectations of rate hikes were evident from the direction of the yields of 10-year US Treasuries. These yields are now at 4.81 per cent. This level was at least 150 basis points higher than last year. In fact, US Treasuries have been on the rise since last year when it had bottomed out at 3.20 per cent on June 13, 2003. This has prompted some of the foreign institutional investors to reduce their holdings in India and remain liquid, traders said. FIIs throughout the week remained net sellers in equities.

The repos auction last week raised about Rs 10,000 crore. The previous week, the mop-up through the repo was Rs 17,000 crore.

The mop-up amounts has been falling consistently. Moreover, the weighted average yield on the 364-day T-bill auction was 4.53 per cent and the cut-off yield was 4.44 per cent. During the previous 364-day T-bill auction, the yield was 4.45 per cent.

This was the first time since reduction of the repo rate last year that the weighted average yield on 364-day bills was above the repo rate of 4.5 per cent. The reason for this trend was that non-competitive bidders for 364-day securities disappeared.

Only the 91-day yield remained at 4.42 per cent, unchanged from the previous week. This was partly because of the large coupon payments. Coupon and redemption flows were about Rs 2,900 crore. This support is unlikely to be available next week. Signs of tightening liquidity situation were reinforced further by the rising 10-year yields.

Ten-year yields on a weighted average basis rose to 5.24 per cent, down from the previous week's 5.21 per cent.

Trading volumes remained thin. The average volume was barely Rs 3,500 crore. Even this level is likely to fall in the coming weeks.

Evidence of low interest was visible from the continuing wide spreads between one year and 24 years. The spread was about 160 basis points.

Even in this market there were large sellers. Among the large sellers were insurance companies, including the Life Insurance Corporation of India. Among the securities that LIC had sold was the 8.35 per cent 2022. As a result, yield on this security dropped by almost 12 basis points. In the case of the 6.01 per cent 2028, there were only offers to sell. There were few takers even at YTMs of 6.13 per cent.

The low interest in long-dated securities was on account of bankers' wariness of the long end of the yield curve.

"When liquidity is expected to tighten, stay away from long-dated securities," one trader opined.

What also pointed to tightening liquidity situation was the foreign exchange flows. Foreign exchange inflows have now virtually stopped. This was evident from the figures released by the RBI, which indicated a $56 million drop in the foreign exchange reserves. This is the first time in three years that the reserves were actually falling.

In the past, the declines were mainly on account of Government's prepayments of multilateral loans.

The main reason for the decline was that current account and non-debt capital account flows have virtually stopped.

Exporters have begun deferring their receipts, though import demand has still not taken off, despite the low forward premia. Only external debt service obligations were being covered.

During the period, with inflation up at 4.67 per cent, real yields turned negative for up to four years. Traders expect real yields to self-correct during the next few weeks and begin moving in line with international levels.

The tightening liquidity also meant that the first round of borrowings by the Government was likely to face some difficulty.

The 6.01 per cent 2028 is to be issued next week to raise Rs 4,000 crore. Credit offtake was also down.

Non-food offtake during the fortnight was only Rs 82 crore, the lowest since the beginning of the year. Besides, deposits have also dropped during the week by about Rs 6,500 crore in the banking system.

Some of the major sanctions have not yet translated into offtake.

Corporate credit offtake has in fact been deferred till the Budget, bankers said.

But corporate costs are on the rise. Yields on `AAA' rated public sector papers were at least 100 basis points over comparative sovereign yields.