The Hindu Business Line : Reverse repo rate hike

The RBI Governor, Dr Y.V. Reddy (second from right) along with his deputies (from left) Mr V. Leeladhar, Ms K. Udeshi, and Ms Shyamala Gopinath, on their way to announce the Credit Policy in Mumbai on Thursday. — Paul Noronha

Mumbai , April 28

THE hike in the reverse repo rate by 25 basis points, from 4.75 per cent to 5 per cent, is a big negative as far as the bond market is concerned.

This is a signal that interest rates might rise in future. Some dealers in government securities even fear that this may even sound the death knell for primary dealers (PDs).

This rate hike had come as a bolt from the blue, said a dealer and would lead to further bleeding of PDs.

According to Mr Jayesh Mehta, Executive Vice-President, DSP Merrill Lynch Ltd, the repo rate hike is a preventive measure taken by Reserve Bank of India. It is targeted at containing inflationary expectations arising from the high level of crude and other commodity prices.

He says, "While RBI is bullish on growth, it expects inflation to be benign. Against this backdrop, we are not bearish on the debt market."

Mr Romesh Sobti, Executive Vice-President and Country Representative, ABN-Amro Bank, said, "The hike in the reverse repo rate by 25 basis points clearly indicates RBI's move on inflation management while keeping the growth story going. RBI appears to be concerned about the rise in prices of fast moving consumer products that indicates growing pricing power of producers and the potential of imported inflation caused by rising oil prices. With a large government borrowing programme in place, such a policy signal will mean interest rates will look upwards."

Under the FRBM (Fiscal Responsibility and Budget Management Act), RBI will be out of primary auction and PDs will have to pick up the entire 100 per cent of the auction of G-Securities, from April 1, 2006.

"But we may not be able to do it. We have capital of only Rs 50 crore and at every auction people are losing money," said a primary dealer.

This should ideally be combined with risk management tools such as exclusivity in primary auction for PDs and introduction of "When Issued market," said another primary dealer.

Mr Sobti said, "The policy refers to a proposal to PDs to be included within the bank entities. This would give the PDs access to more capital and also larger marketing muscle to market government securities and infuse life into what is now a moribund business.

"The proposal for consolidation of government debt and building up of large liquid securities is a precursor to products like STRIPs (Separate Trading for Registered Interest and Principal of Securities). The move towards a (T+1) settlement system for government securities will improve market hygiene."

In order to increase the depth of the government securities market, RBI has permitted sale of government securities allotted in primary issues with and between CSGL (Constituent SGL) account holders on the same day. However, most PDs view this as a small benefit. "CSGL accounts for just 5 per cent of the entire G-Sec market. This is not a big benefit," said a primary dealer.

While the reforms for the bond market are positive, the speed of implementation is crucial, Mr Mehta added.

"For PDs to manage interest rate risk, they should be allowed to participate in a limited way in the forex markets, particularly forex derivatives as a limited authorised dealer. This becomes more imperative as we move to a system where PDs would be responsible for underwriting the entire borrowing programme and therefore able to manage risk better," he added.

"As of now PDs seem like an unsustainable business model. The Primary Dealers Association has put forward demands and we want a safety net," said a primary dealer.

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