The yield on the 10-year benchmark government bond on Friday rose beyond 7% after the government announced plans to raise Rs2.41 trillion from the market in the first six months of the fiscal year beginning 1 April. Unless there is a dramatic drop in bond yields in the next two days, banks will have to provide for an erosion in the value of their bond holding, or so-called mark-to-market (MTM) losses, when they close their books for the current fiscal. This will lower their profits. Bond yields and prices move in opposite direction. As yields rise and prices drop, the market value of banks’ bond portfolio drops, and they need to set aside money to cover such losses.
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Despite this, Indian banks are unlikely to lose interest in buying government bonds as such investments at this point are assuring risk-free high returns. Bond yields have been rising steadily since the first week of January when the benchmark 10-year bond yield dropped to a record low of 4.86%. The choice before banks is to use their money to buy zero-risk sovereign bonds that are offering high returns or lend to companies and individuals. On loans, they can earn higher returns, but there is the risk of creating bad assets if they lend aggressively when economic growth is slowing. They will be required to set aside money to cover bad assets, and that could be higher than the provisions they would need to make against MTM losses on their bond holdings.
Reserve Bank of India governor D. Subbarao said the central bank would manage the government’s borrowing programme in such a way that causes the “least disruption”. Indeed, the central bank’s approach will be non-disruptive, but it will not be able to check the rise in bond yields. The rising yields will disrupt the credit market and have a crippling effect on the near-term recovery prospects of Asia’s third-largest economy. The year-on-year credit growth till 13 March has been 18.1%, down from 21.9% in the year-ago period, and the growth rate will be even lower in the next fiscal.
Going by the government’s market borrowing calendar, released by RBI on Thursday, in the first three months of the next fiscal, beginning April, Rs12,000 crore will be raised every week, making it Rs1.44 trillion for the quarter. In the next quarter, every week the government will roughly borrow Rs8,000 crore from the market and overall Rs97,000 crore.
To be sure, the net borrowing amount—the gross borrowing minus redemption of bonds sold earlier—will be much less. For instance, Rs33,000 crore worth of intervention bonds and Rs9,000 crore of short-term treasury bills will be redeemed in the next six months. These bonds and treasury bills were floated under the so-called market stabilization scheme, or MSS, to soak up excess liquidity that was created because of RBI’s intervention in the foreign exchange market. The Indian central bank was buying 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, will also be 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. If one takes into account all these, then the net government borrowing from the market in the first six months of the next fiscal will be around Rs86,000 crore—certainly higher than what the government traditionally borrows in the first half of any fiscal year but not an amount that can disrupt the market. But 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 new bonds.
So, despite the policy rate being brought down from 9% to a historic low of 3.5%, the loan rates are unlikely to come down. Quite a few public sector banks last week announced a reduction in prime lending rates, or the rates at which they offer loans to their best customers, effective 1 April, but no bank will be able to dramatically bring down its actual loan rates unless bond yields drop. Indeed, the rate at which a bank gives loans depends on its cost of deposits and not bond yields, but one cannot completely ignore the correlation between the bond and credit markets. First, bankers will always get tempted to earn 7% and more on risk-free government bonds than, say, 8% on mortgages or 10% on auto loans that run the risk of default. Besides, after buying bonds, they will be left with very little money to give loans to borrowers. Second, in sync with government bond yields, corporate bond yields will also go up, making it difficult for firms to raise money from the market. In fact, fresh issuances in the corporate bond market have already dried up.
Subbarao’s biggest challenge in the new fiscal is not only maintaining stability in the bond market but also keeping yields low. A failure to do so will delay economic recovery as bank credit will be scarce and expensive.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as a deputy managing editor of Mint. Comments are welcome at firstname.lastname@example.org