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Bond Street keenly Awaits Credit Policy

Will Jalan do a Greenspan is the million-dollar question as market players heatedly debate the efficacy of a rate cut

It was an unusual week for the bond markets with firm bond prices despite a spurt in call rates. Although the auction of Rs 8,000 crore received an encouraging response, it did create a liquidity crunch during the reporting week with call rates shooting to 12.5 per cent on persistent demand. However, as expected, the RBI stepped in to prevent any panic and injected Rs 18,230 crore through a flurry of reverse repos. This eased call rates around 8.5 per cent though there were very few deals below that level. With the recent auction, the government has so far raised Rs 96,250 crore and completed 81 per cent of its targeted borrowing programme for the fiscal. The unusually high pace of mobilisation is attributed to poor revenue collections due to a slackening economy.

On the other hand, expectation of a rate cut kept the sentiment intact on the Bond Street though there was a negligible change in yields at close. The benchmark 10-year paper (11.5%, 2011) ended practically unchanged at 9.10 per cent. While the sentiment was upbeat initially, it turned cautious towards the end of the week as participants, unsure about the rate cut, refrained from fresh buying. The market now keenly awaits the direction of interest rates when credit policy is unveiled on Monday.

The rupee held its ground against the greenback and ended at 48.03 though it had rallied to 47.96 mid-week on the back of steady dollar supply and soft crude oil prices. Amidst the current gloom, it was a positive surprise for the market with a 33 per cent spurt in FDI inflows in the current calendar (till August 2001). The inflows at $3.19 billion are comforting despite the global slowdown and controversy surrounding the Dabhol Power Project. However, it remains to be seen whether the trend can be sustained in this volatile scenario. The forex reserves also crossed $45-billion mark during the week.

Will He, Won't He?
Market participants are debating the chances and importantly, the impact of a rate cut at this juncture. The opinions are sharply divided – the hopefuls expect that interest rates will be lowered to pull the economy from the morass with demand for non-food credit growing by only 10.50% this year. The falling industrial production and low inflation strengthen the case for a rate cut. Further, with falling revenue collections and spiraling fiscal deficit, pump priming seems to be a remote possibility. On the other hand, a section of the market feels that a rate cut is unwarranted since markets are flush with liquidity and RBI is dexterously deploying other measures to maintain soft interest rates. In fact, the central bank itself has talked about the limitation of lower interest rates in spurring growth. Importantly, banks can now lend at sub-PLR levels and thus, this section sees RBI reducing bank rate only on definite signs of a pickup in credit demand. Last but not the least; the external situation continues to be fluid and hence, RBI may not want to rollback a rate cut (like last year) if the rupee comes under pressure.

Banks in a Bind
Amidst the current uncertainty, the banking industry is caught in a piquant situation. With a slack demand for credit coupled with banks' fears for NPAs, there has been little disbursement from banks while deposits have grown at an astronomical pace. Thus, the industry has been heavily investing in government securities and has kept the momentum going despite some odds with a surfeit of liquidity. Thus, banks want RBI to lower interest rates to boost capital gains on their underlying portfolios. However, the sector does not wish a bank rate cut since it will put spreads under pressure due to their inability to bring down deposit rates in isolation. Instead, they want that a bank rate cut be accompanied by a similar reduction in administered rates on small saving schemes. Well, we'll soon know!

While a bank rate cut is unlikely, the RBI may lower repo and CRR rates to bring down short-term interest rates. Though short-term rates have come down, the spreads are still narrow – while the yield on recently auctioned 365-day T-bill was 7.18 per cent, the yield on 25-year sovereign bond is 10.05 per cent. This means an excess return of only 287 basis points for 24 years! A cut in repo rate is likely to trigger fresh buying though the yield on the benchmark may face resistance at 9 per cent. On the other hand, downside is limited in the absence of a rate cut since banks would plug any sharp mark-to-market losses on their G-Sec portfolios. Call rates are also expected to stabilise with the beginning of new reporting fortnight. While war continues to move along expected trajectory, it very much poses an event risk for the markets.