Mumbai: The yield on the 10-year benchmark government bond is a barometer of the interest rate movement. The yield and prices of a bond move in opposite directions. When the prices of a bond go up, its yield moves down and vice versa.
At the beginning of the just-concluded 2006-07, the 10-year benchmark paper yield was 7.52%. By the end of the financial year, it was 7.97%. This means, the 10-year paper yield in 2007 rose by less than half a percentage point.
This gives one a wrong impression about the interest rate trajectory in India in a year when the Reserve Bank of India (RBI) raised its short-term policy rate five times and contracted liquidity in the system. While yield on the 10-year benchmark bond rose by less than half a percentage point, rates for personal loans, auto loans and mortgages went up by about three percentage points and commercial banks have raised their prime lending rate—the rate at which they lend to their prime borrowers—by more than two percentage points.
So, there is a distinct disconnect between the interest rates of different asset classes. The rates of loan assets are rising faster than the rates of government bonds. What is the reason for this anomaly?
Before we answer this, let’s look at another anomalous situation. On 30 March, the yield on the shortest sovereign instrument 91-day treasury bill was 7.98%, one basis point higher than the yield on 10-year bond. In the beginning of the year, the difference between the yield or interest rate of 91-day treasury bill and 10-year paper was 141 basis points, with the 91-day treasury bill yield being 6.11% and 10-year bond yield 7.52%.
What we are seeing today is an inverted yield curve with interest rates of short-term papers being higher than the rates of long-term government papers. Theoretically, an inverted yield curve signifies a slowdown in the economy and a rate cut by the central bank. In the US, an inverted yield curve signals recession nine out of 10 times.
However, this is not the case now in India. The government bond yield curve, at this point of time, signifies more of demand-supply mismatches than recession or an impending cut in interest rates by the central bank.
Last week, this column discussed how short supply of government bonds created volatility in the overnight call money in market where banks were forced to borrow one-day money at 80% in the last week of March. The overnight call money market is only the proverbial tip of the iceberg. The short supply of government bonds is actually distorting the entire interest rate architecture in India. As long as the banks are required to invest 25% of their deposit liabilities in government bonds to fulfil the statutory liquidity ratio (SLR) requirement under the banking law, this anomalous situation will continue. Too many banks are chasing too few bonds, hence bond prices are going up, artificially keeping the yield at a lower level.
As per Section 24 (2-A) of the Banking Regulation Act, 1949, banks are required to maintain a certain percentage of their deposits in cash or gold or government bonds with RBI. The ceiling for such a requirement is 40% and the floor 25%. If a bank fails to maintain the required amount of SLR, it is penalized. The main objective of SLR is to ensure solvency of banks. If a commercial bank faces acute liquidity crunch and needs to pay off depositors’ money, it can always sell its portfolio of government bonds. Besides, this also to some extent restricts the expansion of bank credit and forces banks to allot a portion of their resources to support the government’s annual market borrowing that bridges fiscal deficit. At present, the SLR is 25% but President A.P.J. Abdul Kalam has approved an ordinance empowering RBI to bring the SLR below 25%. RBI is in no hurry because, if it is does so, commercial banks will more aggressively chase loan assets that have grown at about 30% for three consecutive years now and created bubbles in certain segments.
The definition of SLR varies from country to country. In India, SLR is imposed on the entire liability of the banking system, but in Egypt, banks are required to invest 20% of their local currency assets and 25% of foreign currency assets in government bonds. Again, the central bank of Brazil directs its banks to invest in government bonds 70% of their demand deposits, 20% of time deposits and 15% of savings deposits. In Thailand, SLR is applicable to 6% of all deposits and the entire foreign borrowing of banks that have one-year maturity.
Bangladesh and Sri Lanka have 20% SLR each and Nepal and Bhutan 10% each. Some countries have an even higher SLR than India. Ghana has 43% SLR and Maldives 35% while Gambia, Jordon, Latvia, Lithuania and Malta have 30% SLR each. On the lower side, Venezuela has 0.17% SLR, Singapore 0.18% while Spain, Poland and the US have no SLR. The UK has no standard SLR, it varies from bank to bank.
With their deposit liabilities growing fast, Indian banks are required to buy more and more government bonds and the demand is not only distorting the yield curve of government bonds, but also that of the entire interest rate spectrum. It is high time RBI cut the SLR. If it finds a few banks too aggressively chasing loan asses, and it does want them to do so, RBI can always follow the UK model and impose higher SLR on the errant banks. It can simultaneously hike interest rates and bring down the SLR to maintain a tight money policy. These actions do not contradict each other.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as the Mumbai Bureau Chief of Mint. Your comments on this weekly column are welcome at firstname.lastname@example.org