RBI announcement on Rs 10K crore bond purchase lends respite to rising rates

The announcement by RBI on Tuesday to purchase Rs 10,000 crore of Government bonds under open market operations to help in liquidity management has lent some comfort to bond markets.

The yield on 10-year government bonds that have ironically moved up sharply since the RBI’s rate cut in August last year, were set to harden further after the RBI’s recent rate hike. The rising yields have also nudged banks to hike lending rates since January this year, dampening the hopes of significant recovery in bank credit.

Open market operations

The RBI's announcement is a welcome move that will ease liquidity and the upward pressure on yields to some extent. This should in turn limit the hike in lending rates by banks. But the key lies in continued OMOs to cool off rising rates and drive a substantial recovery in lending activity.

On the rise

Concerns over rising inflation on the back of uptick in global oil prices, tightening of global liquidity as global central banks look set to move away from excessively easy money policies, and worries over India’s fiscal slippages -- have led to the yield on 10-year G-Sec rise sharply by 1.4 percentage points since August last year. Hence, despite the RBI’s sanguine monetary policy stance up until now, bond markets have been on tenterhooks.

The recent hike by the RBI in its policy repo rate by 25 basis points has further hardened the yields. The central bank’s change in valuation methodology of state government securities has also been a dampener. The RBI had allowed banks to value their holdings of state government securities at a fixed markup of 25 basis points above the corresponding central government bond.

Given that the spread between state and central government bonds is much higher than 25 basis points, this had in turn allowed banks, to cap actual the trading losses to some extent. The RBI now requires banks to value traded state government securities at the price at which they have been traded in the market. This could lead to Treasury losses for banks and also dampen the demand for such bonds, hence leading to rise in yields across central government bonds and corporate bonds as well.

Demand dynamics

One of the key factors which has been at play in the bond markets, has been the ample appetite for government bonds, both from overseas as well as domestic investors in 2017. On the domestic front, banks, particularly PSU Banks, flush with liquidity post demonetisation have been lapping up government bonds.

PSU banks had net bought government bonds to the tune of about Rs 40,673 crore in 2017 (including t-bills and SDL). In 2018 so far, they have net sold Rs 34,817 crore of government bonds. Foreign portfolio investors (FPIs) too have sold $5.2 billion worth of Indian debt so far.

Hence rising yields and weak demand after the RBI’s tweak in valuation of state government bonds have only added to bond market worries. Going by the data so far, PSU banks appear to be offloading state government bonds (Rs 905 crore in June).

The RBI’s latest announcement of purchase of government bonds, could thus ease some of the bond market concerns and cool off yields. But given the unfavourable demand dynamics, rising global yields and uncertainty over RBI’s future policy stance, bond markets are likely to remain jittery. Further OMOs are hence imperative to cool off yields and cap hikes in lending rates by banks.

Credit growth still languishes

While credit growth has inched up notably in FY18 growing by about 10.3 per cent YoY, it is still below expectations and lags the overall growth in the economy. The seemingly significant uptick in credit growth is thanks to the low base in FY17, when credit grew at decadal low levels of 5-odd per cent.

Also in relation to the overall pace of economic growth, credit growth is far from heartening. In the past, until 2013, credit growth has been 2.5 to 3 times the real GDP growth. But in the past three to four years, bank credit has grown by a smaller multiple to the growth in GDP, owing to weak credit offtake in public sector banks. In FY15 and FY16, credit growth has been about 1.2 times the real GDP growth. This fell sharply to 0.7 times in FY17.

In FY18, while credit growth appears to have recovered, it continues to lag the growth in the economy. Credit growth has been about 1.5 times the real GDP, still lower than the multiples in the past.

While the growth in the economy, according to MOSPI estimates, has shot up in the fourth quarter of FY18, rise in lending rates and continued pressure on asset quality, appears to have impacted credit growth.

Banks have hiked their benchmark lending rates by 5-40 basis points since January, dampening hopes of recovery. Keeping rising rates under check will be imperative to drive credit growth, as the economy chugs along the recovery path.

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