The Hindu Business Line : Receding inflation softens bond yields

Oil companies took advantage of the low forward premia, hedging their payment obligations for crude oil imports. Oil prices are already at close to $65 a barrel, on account of the US government replenishing/increasing its strategic petroleum reserve.

However, forward premia dropped to under 3 per cent for the first time in two years. The drop was largely on account of anticipated external commercial borrowings. Several corporates have lined up their issues to take advantage of lower financing costs.

RBI intervention

In addition, bankers said, foreign companies had also lined up more inflows into the country as part of their additional equity investments in the country. This included foreign partners of private sector insurance companies. In fact, most of the foreign exchange flows were on the capital account. The trade account is on a deficit of close to $7.1 billion.

The capital account driven inflows prompted the Reserve Bank of India to intervene in the exchange markets. In addition, deposits surged in the banking system. Time deposits in the banking system have grown by over Rs 21,000 crore in the last fortnight. This led to liquidity build up.

The liquidity surge was evident from the bids made at the weekend liquidity adjustment facility (LAF) auctions. At the weekend LAF auctions, banks made bids of Rs 81,575 crore for Reverse Repurchase window. But the RBI accepted only Rs 2,996 crore. Besides, there was no issue of the market stabilisation scheme securities other than MSS Treasury Bills.

T-Bill auctions

The liquidity surge pushed down yields at the weekly T-Bill auctions. At the 91-day T-bill auctions, the cut of yield dropped to 7.39 per cent down from 26 basis points from the previous week to 7.65 per cent.

The weighted yields fell to 7.27 per cent down 33 basis points over the same period. The combined bids (competitive and non-competitive) together comprised Rs 7,683 crore or about 3.8 times more than the notified amount of Rs 2,000 crore.

The RBI accepted only Rs 3,350 crore. Despite, the fall in the T-bill yields, there is little expectation of any change in the repo rate at the moment. One reason for this was that the yield was still within the repo/reverse repo rate band. In the case of the 182 day T-bills, the cut off yields were 7.62 per cent. The wide spread is indicative that the bias was still in favour of short-term securities.

Yet this bias notwithstanding, the 10-year yield to maturity softened to 8.14 per cent last week on a weighted average basis, off the previous week's 8.17 per cent, implying that the imminent rally in the debt markets was in the nascent stages.

Firm undertone

The undertone was firm, though daily trade volumes remained modest. Daily trade volumes were nowhere close to those seen in 2003, when they exceeded the equity market. But yields remained soft despite the absence of Life Insurance Corporation of India and private sector non-life insurers.

Bankers said volumes were also expected to pick up in the coming weeks, as insurers step up their presence for meeting their mandated investments. But fundamental factors also favoured a further softening.

The one-year real yield was 2.45 per cent, with inflation down to 5.06 per cent. This real yield level is at least 100 basis points above global levels.

Bankers said with the liquidity surge, some changes in the RBI's policy rates could be anticipated. This included tweaking of the cash reserve ratio from the current levels, as a liquidity mop up tool.

In fact, this was more likely to be the preferred option, they said, till such time inflation drops with in targeted band over a sustained period. In fact, based on what the money supply numbers indicate,the liquidity is well in excess of RBI's permissible limits.

Preferred limit is that M3 growth match up with nominal GDP growth. However, M3 is growing in excess of 20 per cent, way above the projected nominal GDP growth this year.

CRR intervention

CRR-based intervention has other benefits. The reason: CRR intervention is a low-cost tool. Interest payment on CRR balances is just one per cent.

This would also help the RBI to narrow the deficit in sterilisation, bankers said.

Foreign exchange interventions cost the RBI, since the resources are parked in the form of short-term global gilt-edged assets or cash balances. The average realised yields are just about 4 per cent.

On the other hand, any resort sterilisation would cost the RBI about 6 per cent. The MSS route allowed the RBI to go for slightly longer maturity global investments, though bankers said the deficits still remained.

Bankers added that the liquidity surge by sharp deceleration in credit off take since the beginning of this year. The nominal credit deposit ratio is about 73 per cent, though the incremental ratio has dropped to less than 40 per cent. Bankers said this was a seasonal impact.

Yet, last year during the same period incremental ratios were above 100 per cent.

To offset the impact on net interest margins, dealing rooms are becoming active. Signs of this development are becoming apparent from rising investment deposit ratios. Nominal ratio was 31 per cent. But incremental ratio was 75 per cent.

Incremental G-Sec — deposit ratios was 76 per cent. Yet despite the high ratios, few banks are prepared to reverse the derisking they had undertaken two years ago. Bankers prefer to wait for two more months, when the peak season begins.