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Mumbai: Prime Minister Narendra Modi has loosened government purse strings, swelling cash piles at Indian banks and driving short-term borrowing costs for local companies to a five-year low.

One-year commercial-paper rates fell to 8.54% last week, the lowest level since October 2010, and the overnight interbank rate has averaged the least in four years this month. Lenders, which borrowed an average 1,80,000 crore daily from the Reserve Bank of India last quarter to meet fund shortages, are now parking money with the central bank.

Modi has pledged to build roads, ports and airports as he seeks to reverse an investment slowdown in Asia’s third-largest economy saddled with bad loans and stalled projects. The so- called plan spending in April-May, including that on infrastructure, was 13.4% of the amount budgeted for the year ending March 2016, compared with 10.4% in the same period last year.

“Government spending will likely continue as it’s necessary to kick-start the investment cycle," said Killol Pandya, a senior debt-fund manager in Mumbai at LIC Nomura Mutual Fund Asset Management Co., which manages 1,11,000 ($1.8 billion). “The fallout will be that market liquidity will rise, putting downward pressure on yields."

‘Fiscal Space’

An increase in tax revenue has given Modi ammunition to boost expenditure to drive economic expansion. Indirect tax receipts jumped 37 percent in May from a year earlier, the most since 2011. The 47% drop in Brent crude prices over the past year has meant that India, which imports about three- quarters of its oil, is saving money that would normally go toward subsidies.

In addition, dollar-buying by the central bank has also led to a surge in rupee-liquidity, according to Harihar Krishnamoorthy, the treasurer at the local unit of South African lender FirstRand Ltd. The RBI bought $35.7 billion from the spot market alone in the five months to May, official data show, helping propel foreign-exchange reserves to a record $355 billion last month.

“The government has enough fiscal space given the lower commodity prices," said Mumbai-based Krishnamoorthy. “We’re seeing the banking system, which has otherwise been a net borrower of funds from the RBI, now consistently offering money to the central bank."

Lenders have parked an average 34,900 crore rupees a day with the central bank this month. India’s fiscal deficit reached 37.5% of the full-year target through April and May, compared with 45.3% in the same period a year ago.

Yield Curve

Net average banking-system liquidity was in a surplus of about 130 billion rupees as of 11 July, compared with a deficit of 5,74,800 billion rupees at the end of 27 June, according to estimates by Kotak Mahindra Bank Ltd.

Twelve-month commercial-paper rates have slid from this year’s high of 9.29% in February as RBI Governor Raghuram Rajan lowered the benchmark repurchase rate three times this year. The yield on five-year AAA-rated company debt has dropped just 13 basis points this year to 8.54%.

That’s helped erase an inversion in the corporate yield curve, with one-year paper yielding just 3.5 basis points more than five-year bonds on Monday. The negative spread was at a 17- month high of 88 basis points in February.

“We expect liquidity to remain in surplus for a while, which will have a benign impact on short-term rates," said Arvind Chari, Mumbai-based head of fixed income and alternatives at Quantum Advisors Pvt. “The market’s rate-cut expectations and the RBI’s responses to the liquidity situation will determine whether or not the yield curve will steepen further."

Open-Market Auction

India’s one-year interest-rate swaps sank to a two-year low of 7.42% last week as cash supply in the banking system improved. The overnight interbank rate has averaged 7.15% so far in July, the least since 2011, data compiled by Bloomberg show.

The central bank has stepped up efforts to drain excess funds amid concern they could fan inflation. The RBI, which was already mopping up liquidity through unscheduled reverse- repurchase agreements, sold 82.7 billion rupees of sovereign bonds on Tuesday in its first open-market auction since December.

Consumer prices rose 5.40% in June from a year earlier, the fastest pace in nine months, data showed this week. The yield on the benchmark 10-year notes climbed six basis points, the most in two weeks, to 7.87% on Monday, following Friday’s bond sale announcement. The 50-day volatility for the notes jumped 17 basis points to 9.98%.

“Whenever the RBI starts feeling uncomfortable, it will soak the liquidity," said LIC Nomura’s Pandya. “One thing I can assure you of is that this interplay between government spending and RBI steps will lead to higher volatility." Bloomberg

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Updated: 15 Jul 2015, 03:15 PM IST
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