Bonds rallied as banks expected the Reserve Bank India would halt its policy rate hikes on receding inflationary and instead begin infusion of cash into the banking system.
The rise in bond prices was despite the high liquidity deficit as evidenced by the continuing high borrowing from the RBI’s overnight cash support window, at the weekend liquidity adjustment facility auctions. Bank overnight borrowings from the RBI amounted to Rs 83,195 crore. The high borrowings though had little impact on the rally in the bond markets. The price of the ten-year benchmark bond, 8.79 per cent security falling due in 2021, firmed to Rs 101.78 (face value Rs 100) last weekend. This price translated to a yield of 8.51 per cent or close to the upper band of RBI’s policy rate of 8.5 per cent. The previous week, the security was priced at Rs 100.67 (8.69 per cent yield).
But yields are expected to retreat further in the coming weeks in tandem with inflation. Based on the present inflation rates, real yields are presently positive or higher than inflation. For almost two years, real yields have remained negative to the Wholesale Price Index inflation. Even if measured against another inflation measure, the GDP deflator, the real yields are positive. Market expectations were that the RBI was unlikely to make any changes in the policy rates at the moment.
Rating agency Crisil’s chief economist DK Joshi said, “If the inflation numbers sustain, which is what we expect, then a policy rate pause is in order.”
Policy rate pauses though are unlikely to alleviate the cash deficit condition. The cash deficit conditions are partly on the account of the large government borrowings. Last week along, the government borrowed Rs 13,000 crore. In addition, the government drawdown from RBI’s ways and means advances amounted to Rs 36,137 crore.
With banks frenetic pace of deposit mobilisation the rush for government securities for meeting the mandated Statutory Liquidity Ratio (SLR) intensified. The prescribed investment in SLR securities is 24 per cent of the deposits. Last week alone, bulk deposit mobilisation was Rs 3,700 crore per day. It is this demand that has pushed up prices government securities, traders said. The demand for securities raised trade volumes in the secondary markets. Last week, the average trade volume was Rs 21,000 crore per day, according data from the NDS-OM (Negotiated Dealing System- Order Matching).
The cash deficit conditions though are unlikely to vanish in the immediate future. Bankers said that RBI has so far not relented to request for reduction in the Cash Reserve Ratio (Cash Balances that banks maintain with the RBI against their deposits). A reduction of 0.25 per cent would have released as much as 15000 crore into the banking system.
Instead what was offered is continued open market operations. At last week’s open market operations, although there were bids for Rs 20,000 crore, the cash that was pumped was Rs 9,092.901 crore. The open market operations (OMO) also provided a signal for yields. The cut off prices were high at the OMO. For instance the 7.83 per cent security falling due in 2018 was priced at 8.46 per cent. This contributed to driving down the yields.
What also contributed to the chase for investments was the weak credit demand. Corporation Banks CMD, Ajai Kumar said, “Term credit off take is weak, and we don’t see any growth beyond 16 per cent this year.” That meant, banks demand for securities will most likely stay on the up trend.
The demand for investments however did not include corporate bonds. The corporate bond markets remained hamstrung by risk aversion from investors and banks. In fact, most banks have actually offloaded their holdings of corporate bonds to avert depreciation losses. The result was that while sovereign bond yields retreated, corporate bond yields actually stayed firm. For instance last week’s Axis Bank 10-year bond placement was priced at 9.73 per cent or a spread of 122 basis points over the sovereign benchmark.
But public sector banks are not keen on raising capital through the bond markets, at least for the moment. One reason is that some have already reached the limits. Banks are permitted to raise capital in the form of subordinated bonds up to 50 per cent of tier capital (net worth). But other like Corporation bank preferred to wait for the moment. Ajai Kumar, “We have no plans to enter the tier two markets now. We prefer to wait for some more time.” This implied that they would prefer for rates to cool down, before tapping the markets for capital. Capital requirements come in only in event of demand escalation for credit. Credit demand is mostly for working capital from refineries and importers to some extent from refinancing requirements by corporates for meeting their debt service payments on foreign currency borrowings.
The consequent demand for foreign currencies, particularly US dollars kept exchange rates under pressure. However traders said that the pressure could ease in the coming weeks, with the liquidity easing measures in Europe. The European Central Bank reduced its key interest rates, its main refinance rate (that provides cash to the banking system against a collateral of securities for a maximum maturity of one week) to one per cent. Traders said that this move would improve foreign capital flows into the country and somewhat alleviate the dollar shortage plaguing the markets. The Non-deliverable forward (off shore trading in rupees where settlement is in dollars) a leading indicator for capital flows, fell below the domestic spot rate to Rs 52.02 on Friday. For markets this meant a temporary respite from the intense pressure.
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