The Hindu Business Line : Yields harden on fears of fiscal slippages, inflation woes

Traders said the hardening of yields was largely on account of fears of fiscal slippages in the current financial year due to high international oil prices and mounting subsidy bills. Firming of yields continued despite the surfeit of liquidity. Part of the yield hardening was also on account of the third phase of the cash reserve ratio coming into effect. The new CRR, effective from May 24, is 8.25 per cent and would remove another Rs 8,000 crore of liquidity from the banking system.

But with inflation at 7.82 per cent, according to the provisional figures, and well over 8 per cent in the final figures, traders fear that more interventions are likely. The scope for monetary policy intervention is limited, they said. This was because inflows from foreign institutional investors which were one major liquidity source of reserve money expansion had trickled down. This year, so far, the net outflow from foreign institutional investors was $2.9 billion.

Rupee Depreciation

As a result, the Reserve Bank of India hardly intervened in the foreign exchange markets since the exchange rate had moved only one way – down.

The rupee’s depreciation was also fuelled by the oil sector, grappling with large working capital requirements. The rupee-dollar exchange rate remained weak at Rs 42.84, against the previous week’s Rs 42.64. Oil companies’ sale of bonds for foreign exchange and planned sales were becoming evident from the forward foreign exchange markets. One and three month forward premia firmed to 3.5 per cent and 2.8 per cent respectively as oil companies resorted to forward purchase for up to a month, up sharply from last week’s 1.83 per cent and 1.97 per cent. However, longer forwards remained soft, as export driven inflows were anticipated. Six and 12 months remained soft at 1.82 (1.45) and 1.33 (1.15 per cent) respectively.

Oil companies, faced with banks’ reluctance to enhance exposure limits, have been selling their bond holdings for funding their foreign currency purchases. Oil prices are currently at $132 a barrel, which translated into an import price of about $128. At this level, the foreign exchange requirements for crude oil import payments alone are estimated at around $310 million per day on the basis of a current daily import of about 2.44 million barrels.

The large scale bond sell-off has resulted in pushing up yield spreads of oil bonds over comparative sovereign issues, translating into losses for the refineries. The yield spreads are about 100 basis points. But the RBI intervened to mitigate the losses. The RBI notified that the spread over sovereigns would be 25 basis points for marked to market valuation purposes for the banks. The notification, however, did not imply that banks would not be allowed to acquire oil bonds at higher discounts. For the banks the notification eliminated the risk of any steep depreciation losses.

LAF auction

The refineries’ hunger for liquidity, howeve, failed to reflect at the weekly liquidity adjustment facility auction. At the LAF auction, the recourse was to the reverse repurchase window. There were 28 bids for the reverse repo, for a total of Rs 29,610 crore. Yet, a hardening bias of yields was evident from the week-end’s dated security auctions for Rs 10,000 crore. The cut- off yield to maturity (YTM) for the auction of the 8.24 per cent 2018 was 8.07 per cent. For the longer tenure 8.28 per cent 2032, the cut-off YTM was 8.52 per cent. The YTM for the 8.33 per cent 2036 was only 8.44 per cent. At the weekly Treasury bill auctions, the trend was similar. At the weekly 91-day T-Bill auctions, the cut-off yield was 7.48 per cent for a notified amount of Rs 3,000 crore. Bids accepted were Rs 7,000 crore, inclusive of the non-competitive bids from insurers, mutual funds and State Governments. At the 364 day T-bill auctions, the cut-off yield was 7.66 per cent.

The tightening situation was also evident at the weekend ten-year YTM. The ten-year YTM ended last week at 8.08 per cent on a weighted average basis, up from the previous week’s 7.98 per cent.

Average daily trade volume halved to Rs 3,000 crore over the previous week, implying a weak undertoneand low trade interest. But the low interest was also largely on account of the absence of the Life Insurance Corporation and other insurers from the markets. Insurers preferred to wait for some more time till yields hardened further. That such a hardening trend was imminent was apparent from the wide bid offer spreads, that were as high as 15-20 basis points.

Besides, the outlook remained dim for bonds with the hardening yields. One-year real yields continued to remain below inflation numbers. Inflation was higher than the nominal one-year real yield by about 22 basis points, implying upside risks. A trader said, “Inflation is the main concern and we anticipate a Reserve Bank of India response.”

The upside risk does not augur well either for the Government or the oil companies. For the Government, interest costs are expected to rise in the coming weeks, especially for its first half borrowing programme. So far, the Government has raised about Rs 40,000 crore of its planned first half borrowing of Rs 96,000 crore.

Oil bonds, bankers said, would continue to command high discounts to face value, despite the RBI notification. This was partly because there was little interest inlow yield bonds. LIC, for instance, has a yield expectation of at least 9 per cent plus on its Government securities, oil bonds, and other sub-sovereigns. Besides, banks already have an incremental investment-deposit ratio of 144 per cent largely on account of refinery financing. At such high ratios, bankers said there was little appetite for Government securities. Banks currently need only to have a Government security investment of 25 per cent. Besides, with credit off take in the negative zones, deposits have lost their lustre. But the Bank of Baroda Chairman and Managing Director, Mr M.D. Mallya, said, “this is not going to last. We expect credit off take to pick up soon.”

The high pricing of both oil bonds and sovereigns translated into a high revenue expenditure on interest alone. The fiscal targets are beginning to slip on oil to a dead end.