The Hindu Business Line : Yields continue to advance northward on inflation woes

Traders said they still waited for a clear policy response. One policy response was announced in the form of Market Stabilisation Scheme security auctions. The auctions slated for next week was for a mop-up of Rs 5,000 crore.

Clearly liquidity is a problem. The Bank of Baroda’s Chief Economist, Dr Rupa Rege Nitsure, said: “M3 growth is a major issue and has remained well above the designated corridor.”

M3 or broad money supply included currency with the public, demand and time deposits with the banks and other deposits with the RBI. This has grown by about 21 per cent on a year-on-year basis, as against the designated corridor of 15 and 17 per cent.

One source of money supply growth was the sale of US dollars by some of the custodial banks in the domestic market and for cross border arbitrage. Inflows from foreign institutional investors were in the negative zone. Net FII outflow was $552 million since the beginning of this month.

However, a major cause of concern among traders was arbitrage flows. Foreign banks have used the dollar-rupee interest differential to book spreads in excess of 2 per cent on the reverse repo window. The arbitrage inflow was evident from the big increase in recourse to the reverse repurchase window of the Liquidity Adjustment Facility. The recourse was Rs 37,950 crore.

The inflows drove up the dollar-rupee exchange rate back to Rs 39.97 levels from last week-end’s level of Rs 40.10.The arbitrage opportunity was also evident from high short-term forward premia. One month premium rose to 2.70 per cent (2.24 per cent). Three, six and 12 months premia firmed to 2.60 (2.59 per cent), 2.45 per cent (2.14 per cent) and 1.73 per cent (1.52 per cent) respectively.

Alarm bells

The rupee’s appreciation has triggered alarm bells, since it comes on the back of a burgeoning merchandise trade account deficit. The trade account deficit is at about $67 billion, for the first 11 months of the last financial year.

Besides, says Dr Nitsure, “Systemic liquidity is likely to rise in the coming weeks as the government begins unwinding its cash balances of Rs 87,000 crore with the RBI.” The problems in systemic liquidity were also evident from the Rs 1.68 lakh crore of outstanding MSS securities with the RBI. This liquidity build-up pushed down the yield on the 91-day Treasury bill auctions to 6.94 per cent, down 30 basis points from the last week. Bids were Rs 2,633 crore for a notified amount of just Rs 500 crore, but the actual mop-up, that included Rs 4,500 crore of non-competitive bids, was Rs 5,000 crore. At the 182-day T-bill auction, the cut-off yield was fixed at 7.35 per cent. Evidence of some unwinding was apparent from the high non-competitive bids at the 91-day auction. Clearly the excess liquidity build-up appeared to be the provocation for the reinstitution of the MSS. MSS auction next week, as announced by the RBI is for Rs 9,000 crore. This included Rs 3,000 crore through the 91day T-bill, Rs 1,000 crore through 364 day T-bill, in addition to the Rs 5,000 crore of MSS securities.

The excess liquidity belied market fears of the 10-year YTM overshooting the 8 per cent level. The weighted yield on the 7.99 per cent 2017 (maturing on July 2017) and the 6.25 per cent 2018 (maturing in January 02, 2018) was 7.91 per cent, or nine basis points above the previous week’s 7.80.

Volumes picked up. Average daily trade volumes were Rs 4,500 crore. Besides, bid-offer spreads shrank to about 7-10 basis points range. Moreover, what was interesting was that more banks were shifting to the long end of the yield spectrum. This shift pushed up the spread between one-year and 28 years to 100 basis points (74 basis points). Traders said that the shift was largely on account of a slowdown in credit off-take. In fact, the clear message that came out from the widening band was that the credit off-take was likely to remain low. As a result, bonds remained in focus. As a result, more securities from the banks, high coupons, have now come out into the trading ring. The securities that came out included the 11.83 per cent 2014 that was traded at YTM of 8.06 per cent. Besides, with the onset of the lean season, bonds appeared to be the flavour. The outlook as a result was mixed. More banks are expected to move into bonds in a big way during the period. The move was expected to favour the Government’s move to front end this year’s borrowings to the lean season. The first round of borrowings for Rs 10,000 crore is slated to begin with the reissue of the 7.38 per cent 2015 and 7.95 per cent 2032 securities. The liquidity overhang was exerting downside pressure on yields, apparent from the rising incremental investment-deposit ratio. Investment-deposit ratio for the year 2007-08 was about 42 per cent.

Policy intervention

But inflation at 7 per cent was expected to provoke a monetary policy intervention. As a result, the one-year real rate was just 0.5 per cent, as against an internationally accepted average of about 1.5 per cent, implying that yields could harden. Says the HDFC Bank’s Chief Economist, Dr Abeek Barua: “We can expect a hike in the repo rate or a hike in the CRR or both, to contain the inflation advance.”

The mitigating factor was credit off-take. Incremental credit off-take for the financial year 2007-08 was likely to end at slightly less than 70 per cent. In 2006-07, the ratio had averaged 74.6 per cent. Consequently, even if there was monetary policy intervention, it was unlikely to translate into hikes in lending rates. Dr Barua said “With a credit slowdown, banks cannot afford a hike in lending rates.”