The Hindu Business Line : Bonds gain from RBI’s focus on stability

Bond markets were stable during the year virtually fire-walled from the turmoil in the foreign exchange markets through both active and passive interventions by the country’s banking regulator, the Reserve Bank of India.

The passive interventions were more by way of sending signals through moral suasion, a euphemism for speeches and by the RBI’s Governor/Deputy Governors and periodic press releases. Bankers take the speeches seriously. Those who failed suffered red-lined statements. Traders with some American banks realised this after getting bruised.

Misreading signals

One such speech was in Jaipur on June 30 this year when the RBI Governor, Dr Y.V. Reddy, had said – “While the overall objective of maintaining price stability in the context of economic growth and financial stability will remain, the effort will be to harmonise the deregulation and liberalisation of financial markets with the domestic developments in real as well as fiscal sectors and global developments in international financial architecture.”

The obvious message was: Inflation would be the anchor and money supply would be a subsidiary target. The signal was misread to construe that liquidity would be kept tight. Accordingly, some foreign banks had swapped their dollars for rupees to take advantage of a possible tightening in call and collateralised borrowing and lending obligations markets. As anticipated the tightening took place as several banks took recourse to the RBI’s repurchase window during the last few weeks of the year.

So when the RBI issued a press release on December 12 paring the notified amounts for Treasury bill (T-Bill) auctions, without the Market Stabilisation Component, few anticipated it. The signal was that the current liquidity levels would be maintained. As a result, the year-end tightening ahead of advance tax payments failed to happen. Foreign bankers consequently were left chasing T-bills for parking their funds. There were 49 bids at the auction. The chase pushed down yields to 7.44 per cent, from 7.52 per cent.

Winning admirers

The banking regulator had outwitted the foreign bankers. It is these deft moves that have won the RBI admirers. Global strategist of Hong Kong-based brokerage and investment bank CLSA, Mr Chris Wood, said at conference on the sub-prime crisis, “My favourite world central bank is the RBI. It responsibly targets growth and inflation. The RBI talks less and acts tough.”

But with the inflation and stable liquidity as the core focus, the Cash Reserve Ratio (cash balances to be maintained by commercial banks with the RBI as a proportion of their demand and Time liabilities) was hiked from 6 per cent on March 30 to the current level of 7.5 per cent. In addition to the hikes, there were also issuances of longer term MSS securities to remove the excess liquidity.

The CRR hikes and increased MSS issuances were carried out in response to the massive RBI intervention in the foreign exchange markets. The subsequent liquidity impact has seen reserve money growth galloping to 34 per cent. Overall money growth still remained way above the targeted band of 15-17 per cent at about 23 per cent. The CRR hikes and MSS issues were made to contain the money supply expansion. Peculiarly, this is a tactic that the People’s Bank of China is also beginning to adopt.

Narrow spreads

In the peak season Credit policy, the cap of Rs 3,000 crore on reverse repurchases was removed. Yet despite removing the cap, the repurchase and reverse repurchase rates were maintained at 7.75 and 6 per cent, implying aversion to excessive volatility in interest rates and instability in the money markets. The message went down. The 10-year yield-to-maturity (YTM) therefore remained rangebound, between 7.80 and 8.15 per cent.

But the pursuit of stability resulted in narrow spreads. The spread between the 91-day T-bill and 10-year yields in April was about 25 basis points. In the last week of the trading for 2007, the spread was about 40 basis points. The narrow spreads were also partly on account of credit offtake slow down. The credit-deposit ratio since the beginning of this financial year was down to 45 per cent, against 80 per cent during the corresponding period of the last financial year.

Faced with this slow down, more banks parked funds in short term securities. For the same period investment deposit ratios moved up. Government securities investment-deposit ratio since the beginning of this financial year was around 52 per cent, more than double the statutory liquidity ratio of 25 per cent of Demand and Time Liabilities. For the corresponding period of last year, this ratio was barely 20 per cent.

Stable yields, a bonus

But the preference for long term securities was mainly from life insurers. Life insurers moved into Government securities after booking large profits in the equity markets. The BSE Sensitive Index breezed past the 20,000 mark last month. This was driven by anticipation of a further correction in the equity markets. As a result of this return to long-term securities, the spread between on year and 29 years has shrunk to 56 basis points.

For the government, the stable yields were an unexpected bonus. It would imply that interest costs would be within the numbers projected in the Budget for 2007-08 or even lower.

The Government had projected Rs 1.59 lakh crore as interest for the current year. Government borrowings for the current year is estimated at Rs 1.51 lakh crore, of which 84 per cent of the targets have been completed.

In fact, the Government does not actually require the borrowings, in view of the tax buoyancy. The borrowings were now being done largely for open market operations.

But the open market operations are likely to slow down. This is because of the deceleration inflows from hedge funds. However, flows from long-term cross border investors, including non-resident Indians are likely to accelerate in the coming weeks.

This is on account of rate differentials between dollar and rupee of about five per cent. The new flows are less volatile. Besides, banks are sitting on large deposits piles. Deposit growth has remained upwards of 25 per cent, growing faster than credit at 21 per cent. Net interest margins of banks as a consequence are under pressure.

Deposit rates are consequently under pressure. For borrowers, interest rates are likely to come off their present levels.