Mumbai: India’s bond and currency markets enter the New Year in a state of conflict as a global economic downturn looks set to deepen.
While the central bank will likely lower interest rates aggressively to shield the economy from global recession, pushing bond prices up and yields down, the same cuts could extend the rupee’s depreciation against the dollar and reduce India’s attraction for foreign funds.
Bond prices and yields move in opposite direction. Bond dealers are certain of reaping the benefits of declining interest rates, at least in the first quarter of 2009, and currency traders forecast a “downward bias” for the rupee.
Since October, the Reserve Bank of India (RBI) has cut its key repo rate, at which it infuses liquidity into the banking system, by 250 basis points (bps) to 6.5% to ease a credit crunch in the economy. The central bank also reduced its reverse repo rate, the rate at which it drains liquidity, by 100 bps to 5%.
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The cash reserve ratio, or the proportion of deposits banks are required to park with the central bank, was reduced by 350 bps to 5.5%. One basis point is a hundredth of a percentage point.
This year has been a roller-coaster ride for the bond market, with the yield on 10-year government paper rising to a seven-year high of 9.5% in July and dipping to a four-and-a-half-year low of 5.5% now as RBI first attempted to douse inflation and then to stoke slowing economic growth.
Inflation cooled from a 16-year high of 12.91% in August to 6.61% in December as oil prices tumbled from a peak of $146 (Rs7,081) a barrel to below $45 in the period. That widened the room for RBI to slash interest rates.
“I have never seen such volatility in the bond market,” said S.S. Raghavan, head of treasury at IDBI Gilts Ltd, a firm that trades in government bonds. “First half was a very hard time. Now it is a sigh of relief, and next quarter will also be a sigh of relief.”
The first-half downturn in the bond market resulted in short-maturity treasury bills yielding almost the same as those of a longer tenure—a phenomenon known as the flattening of the sovereign yield curve. In normal course, longer-maturity bonds yield more.
The curve even reversed in June. The yield on one-year treasury bills was 9.25%, that on three-month bills 8.95%, one-year 9.2% and 10-year 9.12%.
The rate cuts brought a semblance of normality. On Monday, the yield on the one-month, three-month, and one-year bills was 5.05%, 5.1% and 5.13%, respectively. The yield on 10-year bonds was 5.56%.
“The present yield curve is almost flat, but we would see it steepen in 2009 as more clarity on rate cuts emerges,” said R.V.S. Sridhar, senior vice-president of treasury at Axis Bank Ltd.
“It should be a bull market in the initial period of 2009 as the recessionary pressures would still be alive. I don’t expect the rates to shoot up or bearishness in bond market to set in, at least in the initial period,” said Sridhar, adding that the second half could see a correction.
Both Sridhar and Raghavan expect the 10-year yield to drop to 5% or below by March.
Pradeep Madhav, managing director of STCI Primary dealership Ltd, expects the yield to range between 4.9% and 5% by March as RBI pursues monetary easing.
Some bond dealers caution that the sops and economic stimulus measures offered by the government may strain public finances. That may force the government to borrow substantially more from the market, leading to oversupply of bonds and pushing yields up.
The movement of the rupee, which touched its lifetime low against the dollar this year, hinges on the “evolution of the current account”, said Vikas Agarwal, India strategist at JPMorgan Chase and Co. “Most likely, both exports and imports will be under stress, owing to the deteriorating growth outlook, globally as well as in India.”
For the rupee, 2008 brought misery as foreign funds bailed out. After pumping in $17.4 billion in calendar 2007—when the rupee appreciated about 12% against the dollar—foreign institutional investors turned net sellers of Indian stocks in 2008, offloading $13 billion of shares.
India’s foreign exchange reserves tumbled to $254 billion in December from a peak of $316 billion in May, as RBI aggressively started selling dollars in the market to stem the depreciation of the rupee.
The rupee, which started the year at 39.4 to a dollar, fell to a low of 50.65 in the first week of December before paring losses. The currency had dropped about 18.6% against the dollar this year as of Monday.
The 2009 outlook for the currency is uncertain, hinging on external factors, currency experts say.“It’s relatively easy to take a call on bonds now...but it’s very difficult to take a view on the rupee,” said Arun Kaul, chief general manager of Punjab National Bank. “Everything depends upon how the US dollar performs against the other major currencies.”
According to currency dealers, the banking regulator is now shunning active intervention in favour of the rupee, keeping its powder dry for harsher times.
The unforeseen exchange-rate fluctuations caused some firms to drag banks that sold them exotic currency derivatives products to court. Foreign exchange dealers expect that in 2009 companies will stay away from such products and lay more stress on risk management.
“Banks and companies will take currency risk management very seriously in 2009. There is very little regulators can do in face of such volatility; companies have to be on their guard,” said Rugved Dhumale, assistant vice-president at Mecklai Financial, a foreign exchange consultancy.
While Kaul of Punjab National Bank expects the rupee to reach 46.50 against the dollar by December 2009, Dhumale does not want to hazard a forecast. Agarwal of JPMorgan is betting that the rupee will reach 47.50-48 a dollar by mid-2009, if “short-term funding markets do not seize up”. JPMorgan’s end-2009 target for the rupee is 47 to a dollar.
Indranil Pan, economist at Kotak Mahindra Bank Ltd, is more pessimistic on expectations that capital inflows will remain weak. “It could possibly once more test the 51-51.50 levels by end March 2009.”
Graphic by Ahmed Raza Khan / Mint