The government plans to borrow Rs6.06 trillion in fiscal year 2019 to bridge an estimated fiscal deficit target of 3.3% of the gross domestic product (GDP), but the banks have lost appetite for the government papers. It won’t be an easy job for the Reserve Bank of India (RBI), the government’s investment banker, to raise the money in a market flooded with over-supply of papers and diminishing demand for bonds.
Banks in India are required to invest 19.5% of their net demand and time liabilities, a loose proxy for deposits, in government bonds under the so-called statutory liquidity ratio, or SLR, regulation. Against this, the average bond holding of the banking industry is around 30% of deposits. This means, the banks do not need to make fresh investments in government bonds till they pile up new deposits. However, historically, banks have had larger SLR holdings than what the regulation asked for and, hence, this could not be the reason why they have lost appetite for bond buying.
In fact, the banks should ideally rush for risk-free government papers as, wary of accumulating bad assets, they are not willing to bet big on fresh loans. The gross bad loans of the banking sector have already crossed 10% of the loan book and could surge beyond 11% by September 2018. Still, the banks do not want to buy bonds as, with the steep rise in bond yields, they have been forced to book the so-called mark-to-market, or MTM, losses.
MTM is an accounting practice whereby banks are required to value an asset (in this case, their bond portfolio) in accordance with its current market value and not the price at which it was bought. Since the bond prices have been falling (and yields rising), every quarter, the banks need to make good the difference in prices at which the bonds were bought and their current market price.
The yield on 10-year benchmark government paper was 6.65% on 1 April 2017. Last Friday, it closed at 7.56%. Between July 2017 and February 2018, it rose by 140 basis points (bps)—a steep move, which has not been seen in the recent past. One basis point is one-hundredth of a percentage point. Indeed, in 2013, the bond yield rose 213 bps (from 7.11% in May to 9.24% in August, hitting an intraday high of 9.47% on 20 August), but against a very different backdrop—double-digit inflation, a high current account deficit and a fast depreciating local currency.
Between April last year and now, the yield on one-year government paper has risen around 26 bps and that of five-year paper, 60 bps.
Banks have booked thousands of crores in MTM losses through the current year and another bout of treasury loss is staring at them in the March quarter. Apart from the MTM losses, they need to provide for their rising bad loans, too. In the three months ended 31 December, the public sector banks, which roughly have 70% of the share in banking assets and are big buyers of government bonds, posted a net loss of Rs18,097 crore, more than four times the loss in the previous quarter. They don’t have the stomach for government papers any more.
In the current fiscal year (the government has so far borrowed Rs5.87 trillion) around Rs10,296.5 crore have devolved on the primary dealers and between 29 December 2017 and 2 February 2018, eight auctions to raise Rs30,000 crore have been cancelled.
Is the fiscal year 2019 borrowing programme too large for the banking system to absorb? This does not seem so as for the past five years, since fiscal year 2015, the amount has been veering around Rs5.83 trillion (2017) and Rs5.99 trillion (2018). However, during this period, the money raised by the state governments has risen substantially. In 2015, the so-called state development loans, or SDLs, were to the tune of Rs2.07 trillion, which have progressively been rising—Rs2.59 trillion in 2016, Rs3.43 trillion in 2017 and Rs3.58 trillion in 2018.
While demand for money has been rising, there aren’t fresh buyers in the market. The excess supply of the government papers had been absorbed rather easily in the past few years as most banks were going slow in giving loans, or even contracting their loan books. The massive MTM loss in 2018 has killed the sentiment.
What can RBI do to ensure a smooth sailing of the government borrowing? A new year cannot take off with auction cancellations and devolvements.
Here are three ways to restore confidence in the bond market:
One: RBI must bring in variety in the duration of the government papers. The weighted average maturity of outstanding government papers has risen from 9.66 years in 2013 to 10.67 years in the first half of 2018. There is a marginal decline in the average maturity of new supply of papers though—from 14.68 years in 2015 to 13.69 years in 2018.
Shorter term papers of two, three and four years and floaters, or papers with a floating interest rate, may create demand for bonds as they will help banks manage risks better. Also, the government should stop “switching" on-the-run bonds. There have been instances in recent times where the government has bought back bonds maturing shortly and replaced them with longer maturity papers. This helps the government as it postpones redemptions, but challenges the banks’ risk management. Such “switches" are fine with insurance firms, but should not be done with banks as it kills their risk appetite.
Two: We need new players in the market. One way of doing it is lifting the foreign portfolio investment (FPI) limit. Currently, foreign investors can invest up to Rs3.015 trillion in central government loans and SDL. In addition to that, they can also invest the coupon or interest earned on such bonds in fresh papers. As on 21 March, they have not utilized Rs55,628 crore of the limit. A higher limit for FPIs will help create demand for government papers.
RBI can also float longer maturity bonds to create demand from insurance companies. In December 2017, out of the Rs52.8 trillion outstanding government papers, insurance firms’ share was 23.63%, after commercial banks’ 41.4%. Incidentally, Life Insurance Corp. of India, the country’s largest insurer, may not be an aggressive buyer as it has already committed Rs1.5 trillion of funding to Indian Railways by buying bonds of Indian Railway Finance Corp.
Three: Finally, RBI should be prepared to buy back bonds under its open market operations, or OMO. This will infuse liquidity, if needed, as well as give an exit route to the banks from illiquid securities. Besides, such interventions can also iron out the excessive volatility in the bond market—something RBI has been doing in the currency market.
In 2013, it allowed banks to book MTM losses over a period of three quarters. The regulator may consider repeating such one-time dispensation once again to rescue the banks and restore their confidence.
Alternatively, it can allow the banks to reshuffle their bond portfolio to ward off the loss. There are three buckets in a bank’s bond portfolio—held to maturity (HTM), available for sale (AFS) and held for trading (HFT). Banks are allowed to keep the required SLR holding (19.5%) in HTM, and this portfolio is not subjected to MTM losses while bonds in the AFS and HFT baskets need to be marked to market.
RBI allows banks to reshuffle their bond portfolio once a year, typically in the beginning of the year. If it makes an exception and allows banks to shift the bonds kept in AFS to their HTM portfolio, up to the SLR limit, at the acquisition cost, then banks will be shielded from the MTM losses to a large extent. RBI had done this in the past. In fact, in 2013, along with allowing banks to spread their MTM losses over three quarters, it also allowed the transfer of securities from AFS to HTM book.
Indeed, banks must know how to manage the risks. But if they turn risk averse and don’t touch government bonds, we will have a bigger problem. The government, being the majority owner of the public sector banks, can always take the path of moral suasion to convince banks to buy bonds. This happened in the past, but may not happen now as many banks are struggling to survive.
Tamal Bandyopadhyay, consulting editor at Mint, is adviser to Bandhan Bank. His latest book, From Lehman to Demonetization: A Decade of Disruptions, Reforms and Misadventures has recently been released
His Twitter handle is @tamalbandyo.
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