Mumbai: Huge bond sales by a deficit-ridden government should have pushed down bond prices and propelled interest rates far higher than their current levels—thus unsettling the market for corporate credit as well.
That hasn’t happened. The yield on the benchmark 10-year government bond has been hovering around 6.55% despite the government’s massive Rs3.62 trillion borrowing plan for fiscal 2010. Moreover, bankers and bond dealers do not expect any dramatic rise in bond yields in the coming months.
The reason: banks have been only too ready to finance government profligacy.
But there is a conundrum here.
ICICI Securities Primary Dealership Ltd, a firm that buys and sells government b onds, estimates that banks hav e invested around 26% of the depositor funds in government bonds, the lowest so far this century. That is very close to the statutory minimum—24%—required under Indian banking rules.
Banks usually do not take their investment ratio all the way down to the statutory minimum, so that they have some headroom in case they need to borrow short-term funds from the Reserve Bank of India (RBI). Government bonds are offered as collateral for such borrowing.
Even though the average bond holding of the banking system is around 26%, some banks’ investments in government bonds are actually very close to the floor stipulated by the regulator, said a senior Mumbai-based public sector banker, who does not want to be named.
With signs of a fledgeling recovery in different pockets of the economy, a relatively low bond yield is critical even though bank loan rates are not necessarily benchmarked to it. But corporate bond rates are linked to government bonds, making a low yield attractive to companies that often offer corporate bonds to raise funds outside of bank loans.
Rising yields, therefore, can disrupt the credit market and have a crippling effect on the near-term recovery prospects of Asia’s third largest economy.
The government plans to borrow Rs3.62 trillion from the market this year to bridge its growing fiscal deficit. The combined fiscal deficit of the Centre and the states, and oil and fertilizer subsidies collectively account for about 11% of India’s gross domestic product. Last year, the government borrowed Rs2.05 trillion, more than its budgeted estimate of Rs1.45 trillion.
In the first half of the current fiscal year, the government plans to borrow Rs2.41 trillion from the market, of which Rs90,000 crore has already been raised. On Friday, RBI will auction another Rs15,000 crore of bonds. Officials from the ministry of finance met central bank officials on 30 May to speed up the market borrowing programme in June, but the outcome of the meeting is not known.
The government is not finding it too difficult to raise money from banks because of the massive growth in bank deposits. With the equity markets falling to new lows over the past year, risk averse investors pulled out money in the last half of fiscal 2009 and moved it into the safe haven of bank deposits, swelling banks’ resources. At the end of the first week of May, year-on-year bank deposits grew by 22.6%, or Rs7.29 trillion. In contrast, the loan growth has been only 17.2%, or Rs4.04 trillion.
While lower loan growth leaves the banks with enough money to buy bonds, higher growth in deposits forces them to go in for more, as the statutory requirement for bond investment goes up due to the growth in deposits.
“When the credit is not picking up and the system is flush with liquidity, banks have very little option but to park their money in government and corporate securities,” said J.S. Chiney, general manager (treasury and international banking division) at Bank of India.
ICICI Securities Primary Dealership’s chief economist A. Prasanna also said there is no problem at this point as there is enough liquidity in the system, but when liquidity dries up, banks will need more bonds in their portfolio as otherwise they will not be able to get the liquidity support from RBI.
In the past seven days, on an average, banks have been parking about Rs1.22 trillion with RBI daily.
The 10-year benchmark bond yield dropped to its historic low of 4.86% in the first week of January. Since then, it has risen, but the market does not expect it to rise aggressively because of banks’ need to buy bonds apart from RBI’s efforts to manage the government’s borrowing programme in such a way that causes the “least disruption”.
To be sure, the net borrowing amount—the gross borrowing minus redemption of bonds sold earlier—is much less. For instance, Rs33,000 crore worth of intervention bonds and Rs9,000 crore of short-term treasury bills are being redeemed between April and September. These bonds and treasury bills were floated under the market stabilization scheme (MSS) to soak up excess liquidity that was created because of RBI’s intervention in the foreign exchange market.
RBI bought dollars to check the runaway appreciation of the rupee because a strong local currency hurts exporters by reducing the rupee equivalent of their foreign exchange earnings. For every dollar RBI bought, an equivalent amount of rupee flowed into the system and the central bank sucked out the excess money through MSS bonds and treasury bills.
Besides, another Rs33,000 crore worth of bonds, part of the government’s regular borrowing programme, are also being redeemed in the first half. On top of that, RBI is committed to buying Rs80,000 crore worth of bonds from the market between April and September. Taking into account all these, the net government borrowing from the market in the first six months will be around Rs86,000 crore—higher than what the government traditionally borrows in the first half of any fiscal year, but not an amount that can disrupt the market. However, the net borrowing amount is more of an academic exercise as the underlying assumption is that the money released through the redemptions will be used to buy fresh bonds.
With banks’ government bond holdings reaching a new low and no change in the pace of deposit growth, bond yields are expected to remain range bound. This is good news for credit market.