Opinion

Bonds rejoice too soon

RADHIKA MERWIN | Updated on August 21, 2013 Published on August 21, 2013

Looming question… How far will the RBI go to defend the rupee?

While the Reserve Bank of India's measures offer banks a reprieve from big mark-to-market losses, the reaction of the bond market appears overdone.

After playing the ‘bad guy’ for a while now, the Reserve Bank of India finally reversed roles, or at least the bond markets seemed to think so as they rallied on Wednesday.

The yield on the 10-year government bond, which had sky-rocketed to the 2008 crisis level of 9.47 per cent on Tuesday, quickly sank back by 60 basis points taking comfort from the RBI’s new set of measures.

While the measures do offer banks a reprieve from taking big mark-to-market losses, the reaction of the bond market appears overdone.

The falling rupee, which has been central to the RBI’s tightening measures, still remained unaffected, touching an all-time low of 64.4 to the dollar on Wednesday. As long as the currency continues to slide, interest rates are not likely to come down in a hurry.

The ‘good cop, bad cop’ routine from the central bank has only left markets more confused than ever. After a series of tightening measures in the past month, the central bank is now planning to infuse liquidity through the purchase of government bonds.

Saving grace for banks

So why did banks heave a sigh of relief on Wednesday? Thanks to the RBI measures on July 15, which spiked up the short term interest rates, banks were facing large mark-to-market (MTM) losses on their gilt portfolios. These would have severely dented their September quarter numbers.

But the RBI, in its relaxations on Tuesday, allowed banks to transfer these securities to the held-to-maturity (HTM) category from the available-for-sale segment, as a one-time measure, and that too at the price prevailing as on July 15 2013 (the day when series of liquidity measures began). Consider this. On July 15, 2013, the 10-year G-sec traded at Rs 97 as against current price of Rs 91. By giving banks the option to set the clock back on this price decline, the RBI has allowed banks to rid their profit and loss accounts of these pesky MTM losses, estimated at over Rs 50,000 crore at one go.

What is more, current MTM losses on books for the September quarter will be allowed to be apportioned over the next three quarters.

That is not all. In its May monetary policy, the RBI had lowered the amount of gilts that banks could hold in HTM to 23 per cent of Net Demand and Time Liabilities (NDTL) from the earlier 25 per cent. This meant that banks would have had to essentially mark to market more of their government securities.

This limit has now been relaxed to 24.5 per cent. This would mean close to Rs 38,000 crore of government securities not moving from the HTM portfolio for now. More ‘savings’ for banks from MTM losses.

These RBI measures may provide banks with a reprieve from immediate treasury losses. But there are no such quick fixes for the wider issue of slowing credit growth and pressure on asset quality, which continue to impact earnings of banks.

Recent tightening measures and increase in short-term borrowing costs by 200 basis points have stretched liquidity for distressed borrowers and led to a higher possibility of defaults.

Unless long-term interest rates reverse for good and growth recovers, these are but interim doses of relief which do not alter the structural issues that dog the sector.

Reacting too soon

If bank stocks have reason to cheer, what are the bond markets rejoicing at? That’s harder to answer.

Yes, the recent measures are accompanied by a bond purchase programme amounting to Rs 8,000 crore which should mop up some excess supply of bonds.

But there is nothing particularly dramatic in that. RBI announced the sale of government bonds to mop up liquidity almost six times in the last one month, to the tune of Rs 15,000 crore each time.

The other reason for bond markets to rally was that banks could now be expected to make fresh purchases of government securities, with MTM losses done away.

But there are two issues with this assumption.

One, banks are already holding 4 per cent more than the mandated requirement in SLR securities mainly as this helped them to borrow though the Liquidity Adjustment Facility (LAF) window. But with RBI halving such borrowings, there is less reason to hold excess gilts in the portfolio.

In fact, banks which have hoarded SLR investments may now actually sell them to ease up liquidity. This will lead to further pressure on bond yields.

Already on Tuesday, foreign banks who hold 5 per cent more than the mandated requirement have been net sellers in the government securities market.

Two, post the increase of cash reserve ratio requirements, banks have been maintaining anywhere between 105-110 per cent of the CRR requirement on a daily basis, on an average close to Rs 18,000 crore additional cash every day in the last fortnight. This allows less room to buy new bonds.

So what can the RBI do?

Overall, recent measures have highlighted that RBI does want to have the cake and eat it too. That is, it wants to keep short term interest rates high enough to deter speculation, without this impacting growth or borrowing rates for India Inc. But it is the rupee that remains the joker in the pack.

What may help bond markets and banks make the right strategic choices now would be a clearly articulated RBI policy on how far it intends to go to defend the currency. Is the RBI looking at a targeted volatility or level in the exchange rate, at which it will withdraw its drastic liquidity measures?

Is it waiting for the currency to align with its fundamental value, as captured by the Real Effective Exchange Rate?

Statements to this effect may prevent the bond markets from reacting in a knee-jerk fashion to the central banks' ever-changing policies.

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Published on August 21, 2013
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