Government faced with sudden rise in borrowing costs as RBI sells short-term treasury bills at double-digit yield
Mumbai/Kolkata: The central bank’s latest round of liquidity tightening measures as part of its mission to rescue the rupee may help the currency, but could end up hurting the government the most as the Reserve Bank of India (RBI) was forced to give in to market demand and sell short-term treasury bills at double-digit yields on Wednesday.
The rise in yields led bondholders to express their frustration at having to protect the rupee at the expense of debt.
The higher yields also threaten to undermine government efforts to boost growth from the slowest in a decade of 5% in the last fiscal year. The government is faced with a sudden increase in borrowing costs, while companies that want to raise debt may have to pay an even higher rate.
Devendra Dash, a senior bond dealer with Development Credit Bank Ltd, said, “If government has to pay 11%, what will corporates pay for loans and bonds—16-17%? It’s a very difficult situation. Nobody had thought of this kind of rates."
The benchmark 10-year bond yield hit a 14-month high of 8.5%, up 33 basis points (bps) on the day and 95 bps since 15 July, Reuters said. A basis point is one-hundredth of a percentage point.
Still, the various measures have ensured that the rupee strengthened sharply to close the day at 59.15 a dollar from its previous close of 59.77.
Reflecting the rise in yields, banks have already started raising deposit rates, a precursor to raising lending rates. Oriental Bank of Commerce(OBC) raised short-term deposit rates by 50-75 bps across baskets for maturities within a year.
Already certificates of deposit rates have risen by about 200 bps since early July, before RBI’s latest series of measures aimed at draining liquidity. A rise in the cost of funds means banks will be forced to hike lending rates. OBC had just reduced its lending rate by 25 bps earlier this month after the finance minister prodded banks to lower rates to aid growth.
RBI last week refused to sell ₹ 12,000 crore of short-term bills after the market demanded higher yields than what the central bank was ready to give. A higher yield implies a lower price for bonds and also increased liability on the part of the government to service the debt. RBI’s acceptance now of a higher yield in auctions is being interpreted in the market as an indirect rate hardening signal, less than a week before its next monetary policy announcement, scheduled for 30 July.
On Wednesday, RBI sold ₹ 7,000 crore of treasury bills maturing in 91 days at 11.0031%, a jump of 353 bps over its last 91-day treasury bill auction cut-off of 7.4769% on 10 July. It also sold ₹ 5,000 crore of 364-day treasury bills at a cut-off of 10.4649%, up from its 10 July auction cut-off of 7.5476%.
This effectively means that in just two weeks, short-term rates have spiked by 3.5 percentage points, a full 150 bps more than RBI’s indirect rate hike of 200 bps on 15 July, when the central bank tightened liquidity first and told banks they can borrow up to ₹ 75,000 crore from the central bank at the rate of 7.25%. Any extra money would have to be borrowed through the emergency marginal standing facility (MSF) window, at a rate that RBI set at 10.25% versus 8.25% before.
High yields also imply that banks’ bond holdings available for trading have dropped in price. As per accounting rules, banks will have to value them as per the prevailing market price and not at historical prices, showing as losses on their books.
Banks’ bond holdings are now at about 30% of their deposit base, whereas the mandatory minimum is 23%. The excess is mostly held in the “available for sales" category, with the view that interest rates will drop and that they can be sold at a profit. That calculation has been upended—banks are incurring huge losses in their treasury operations, said two treasury heads of public sector banks who didn’t want to be named.
On Tuesday, RBI had said banks can only borrow 0.5% of their net demand and times liabilities and announced the sale of ₹ 6,000 crore of ultra-short cash management bills to suck out further liquidity. Earlier, RBI had done this through long-term dated securities, which the market refused to buy.
RBI also said banks will now have maintain their cash reserves with RBI at a 99% level every day instead of the minimum 70% maintained earlier. On reporting days, banks have to average out this cash reserve ratio at 100%. Banks generally maintain 2-3% more than their daily minimum cash reserve ratio (CRR) requirement, currently pegged at 4% of the total deposit base. The buffer is to take into account asset-liability mismatches as deposit bases fluctuate. RBI wants CRR maintained precisely on the reporting days. Various treasury heads estimate this extra 2-3% will cost banks some ₹ 10,000-12,000 crore in liquidity, effectively hiking CRR.
While the government, including Prime Minister Manmohan Singh, has termed the measures as “temporary", the liquidity squeeze hasn’t gone down well with bankers.
SBI’s Chaudhuri criticized the RBI measures at a banking summit in Kolkata. “If the central bank decides to press the button (for reining in inflation), it should do it in a more open and transparent way," he said, echoing the view that RBI should have hiked the rate at which banks borrow from it (the repo rate) instead of indirectly raising the borrowing limit for banks.
“If you want to curb demand (for funds), make it (repo rate) more expensive rather than making liquidity unavailable," he said. It was clear RBI’s priority was to “protect the currency" but it should have done so by increasing key rates—as is “common for central banks across the world", he said.
“In this instance, RBI’s action has severely affected the bond market, blocking all new bond issues and created panic in the market resulting in hardening of interest rates in the short term,"Chaudhuri added.
“The bond market is dead," he said, but that should not affect SBI as almost all the funding of banks come from retail sources.
The government securities market was “languishing" as a result of RBI’s move and bond auctions were failing, he said. Instead of getting “overwhelmed by short-term goals", RBI should not have lost sight “of long-term objectives".
He also hoped that the rise in the MSF rate was “temporary".
Rana Kapoor, managing director and chief executive of Yes Bank Ltd, adopted a more conciliatory note, saying the measures were necessary to shore up the rupee, which has dropped about 7% this year, making it the worst-performing currency in Asia excluding Japan.
“We think that the RBI action is only temporary just like after the Asian crisis in the late 1990s, when the bank rate jumped to 11% from 9%, but the rates were back just after three months and banks did well after that because they soft landed," he said. “It is just a measure aimed at stabilizing the rupee and these measures will get reversed in some time."
Some were sceptical about the measures being temporary.
“The establishment has been telling the nation that the measure is only short term in nature and there is no change in the stance of the central bank on long-term interest rates. Believe it at your own peril," Jyotheesh Kumar, executive vice-president of HDFC Securities, said in an email to clients.
Economists said any extension of the measures would hit growth.
“We expect these measures to last for not more than a month. However, if the measures were to persist, the higher funding cost of banks may translate into higher lending rates thereby endangering the already weak investment cycle. We expect down-side risks to our GDP growth forecast of 5.5% in FY14, if these measures were to last over a month," ING Vysya Bank Ltd economist Upasna Bhardwaj wrote in a report on Wednesday.
Chaudhuri told CNBC-TV18 in the morning that his bank has seen ₹ 6,000 crore in deposits after investors withdrew their money from liquid mutual funds (MFs) as yields rose and portfolio returns turned negative.
MF executives don’t expect high redemptions from debt funds. “Redemptions today would be normal. Money, typically, flows in and out of liquid funds daily. Today, while redemptions have been low, inflows too have been very low", says R. Sivakumar, head of fixed income and products at Axis Asset Management Co. Ltd.
The Association of Mutual Funds of India lobby group instructed fund houses to value their full portfolios to their market values Wednesday, as an exceptional measure. Typically, securities held by MF schemes that mature beyond 60 days are marked to market. Securities that mature within 60 days aren’t—they are valued through an amortization method in which the value shows a steady, daily rise.