The Reserve Bank of India (RBI) will sell up to Rs.10,000 crore worth of government bonds on Monday to drain excess liquidity from the banking system—the first so-called open market operation (OMO) this fiscal year. The liquidity in the system is in surplus but banks are not in a mood to cut loan rates further. Indeed, most of them have cut their base rate or minimum lending rate twice since January when RBI began its rate cut cycle, but the quantum of cuts is less than half of the cuts in the policy rate.
Since January, RBI has pared policy rate by 75 basis points in three phases, from 8% to 7.25%. One basis point is 0.01%. State Bank of India, the nation’s largest lender, and private banks such as ICICI Bank Ltd, HDFC Bank Ltd and Axis Bank Ltd have cut loan rates by 30 basis points each, bringing down their base rate from 10% in January to 9.7%. Deposit rates of most banks have come down by around 50 basis points.
There are many reasons behind the slow transmission of the policy rate cut. One of them is that a cut in the deposit rate does not translate into immediate reduction in the cost of money for banks, as depositors continue to earn higher rates till their deposits mature but when loan rates are pared, old loans, too, are re-priced.
Typically, banks are faster in cutting their deposit rates than their loan rates, as they are always keen to protect their net interest rate margin. This is why most Indian banks continue to pay 4% on savings accounts even though RBI in October 2011 deregulated savings bank deposit interest rate. The Competition Commission of India is looking into whether banks have formed a cartel to keep the savings rate uniform. The scenario is unlikely to change unless we have more banks. The arrival of small business banks and payments banks may bring in a semblance of competition. As long as banking licence remains a precious commodity, existing banks will not be sensitive to the needs of the saving community or borrowers.
Many fear that the OMO will lead to a rise in bond yields as supply will outstrip demand. On 15 January, the date of the first rate cut in this phase, the yield on the 10-year government bond dropped from 7.77% to 7.69%; on 4 March, the day of the second rate cut, it fell from 7.7% to 7.69%; and, on the day of the third rate cut on 2 June, it rose from 7.82% to 7.93%. The yield is around 7.8% now.
Does this mean rate cuts have no impact on the bond market? It will be unfair to say so. Indeed, yields are still higher than the level seen after the January cut, but they are down from the December 2014 level when RBI gave guidance of a rate cut. In July 2014, the 10-year yield was close to 8.8%. It was around 8.5% in August and September and 8% in October-November, before falling below 8% in December. Clearly, the market had moved ahead of RBI.
Analysts say bonds were overbought before the January cut, as bond dealers were expecting aggressive cuts by RBI, but the central bank’s actions and the policy language in June have forced a rethink. At this point, the market is at best factoring in one more rate cut by December. A. Prasanna, chief economist of ICICI Securities Primary Dealership Ltd, says since the policy rate is going to be at 7.25% or 7% for a long time, the market is trying to arrive at a term premium for the 10-year bond. Usually, in India, the spread between the policy rate and the yield on 10-year paper is very low, but that could probably be undergoing a correction now.
There are other reasons behind a relatively higher bond yield. For instance, fiscal deficit for the current year is higher than what the market had expected and gross market borrowing by the government is almost unchanged. Since there are not too many takers for bank credit in a weak investment climate, banks should be lapping up government bonds, but the pile of bad assets for which they need to set aside money has constrained their ability to do so. Apart from the rate cut hopes, decline in commodity price, the absence of any turmoil and Greece and China also fuelled the year-end rally in government bonds. Globally, the appetite for risk has diminished and RBI’s June commentary added to the bearishness.
The key reason behind the demand-supply balance turning adverse is that FIIs are near their buying capacity limit. FIIs can buy up to $25 billion of government bonds; long-term funds can buy another $5 billion, taking the total exposure to $30 billion. The utilization limit for FIIs is now 99.71% and long-term funds 99.98%. For corporate debt, where the exposure is capped at $51 billion, around 22% has not been utilized. Overall, FIIs’ exposure to Indian debt market is $81 billion and close to 86% of this has been used.
RBI governor Raghuram Rajan recently said that the central bank is committed to expanding the absolute value of investments by FIIs in debt market. This will be done by revising the ceiling twice a year. Ahead of Rajan, finance secretary Rajiv Mehrishi had said the finance ministry was in favour of fixing FII investment limit for government bonds in rupee terms instead of dollar, as it would provide more headroom for FII investments.
If indeed RBI decides to shift to a rupee-denominated limit for FIIs’ investments in debt from dollar, automatically, the exposure will rise by around 25%. This is simply because the exchange rate for FII investments in debt is not market-driven; it is pegged at Rs.49.8 to a dollar. The rupee closed at 63.49 a dollar on Friday. In rupee terms, the FII limit would have been far higher had the exchange rate been market-driven.
It won’t be possible to make it market-driven as volatility in exchange rates will lead to fluctuations in the exposure limit and if the rupee strengthens FIIs would need to liquidate their positions in debt which is not feasible. So, RBI can either make the limit linked to rupee or revise the exchange rate to a realistic level.
FIIs’ exposure to government bonds is not even 5% compared with at least 40% in countries such as Indonesia and Malaysia. With $354 billion foreign exchange reserves and a modest current account deficit, RBI can certainly allow FIIs a larger play in government debt as long as it is done gradually.