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Yields Dip to New Lows on Rate Cuts

Its obvious that the RBI is now over with its series of rate cuts; the ball is now in the government's court to revive the economy

The rate cuts this week infused a fresh lease of life in wayward bond markets with the yield on the ten year benchmark (2011, 11.5%) sinking to a historical low of 8.83 per cent. The RBI cut the key bank rate by 50 basis points while Cash Reserve Ratio or CRR was slashed by 200 basis points. However, with CRR now calculated on an expanded base, the cut is actually lower at 80 basis points and will add another Rs 8,000 crore to the system. After touching a high of 12 per cent last week, call rates eased to below 7 per cent on the back of rate cuts.

Both call rates and yields though, marginally firmed up towards the end of the week, as a much expected repo cut did not materialise. The sharp spurt in bond prices also invited some profit taking with the yield on the benchmark travelling back to 8.90 per cent. The credit policy revealed that the government's maturity programme had elongated this year with a lower cost. The weighted average maturity of borrowing was 13.9 years against 10.6 years a year ago and the weighted yield at 9.96 per cent was lower by nearly 100 basis points.

The rupee continued to stay calm and ended the week at 48 to the greenback after touching a high of 47.98 on improved dollar inflows from banks and exporters. State run banks were seen mopping up excess dollar supplies to keep the rupee stable at 48-levels and augment foreign currency assets. Oil prices inched up with the OPEC considering a cut in oil production by around one million barrels per day. However, it is unlikely that oil prices will flare up due to these production cuts and may well remain below $24 per barrel.

You can Take the Horse to the Pond…….
While bankers and other bond market players were clamouring for a rate cut, they hardly expected one, given RBI's own reservation on efficacy of lower interest rates. Thus, the markets were taken by surprise. That the central bank reduced the bank rate could be due to two reasons – (a) pressure from the government and (b) it wanted to be seen as a pro-active facilitator for kick starting the economy. At the same time, Jalan has highlighted the rigidity in the interest rate structure and shifted the gaze on the government for further reducing the cost of capital. It is obvious that the apex bank cannot cut interest rates in isolation. While an expert committee has recently recommended to the government to introduce a flexible interest rate structure for small savings, the RBI has now also asked the banks to adopt a similar paradigm at the earliest for long-term deposits. The government is currently paying 8.5 per cent for its five-year GoI Relief bonds while the yield on the five-year gilt is 7.28 per cent! Such wide variance for the same issuer and tenure is not sustainable.

The million-dollar question now is – will a 50 basis point rate cut trigger a pickup in credit? While the RBI has been removing supply side bottlenecks, the problem lies with poor demand. Thus, a rate cut alone will not help – it is essentially aimed at bringing down the government's cost of borrowing and facilitate pump priming of the economy. The ball is now in the government's court - the exchequer can either be used judiciously to guide the economy out of morass or frittered away in subsidies and wasteful expenditure. Ideally, the government must also bring down interest rates on small savings to trigger another round of rate cuts that induce private sector participation. However, this is unlikely to happen soon, given the impending elections in Uttar Pradesh.

Banks in a Quandary
It is almost a week since the bank rate was reduced but none of the banks have yet announced a cut in their lending rates. Well, as mentioned last week, the industry in a dilemma. A cut in only lending rate will put banks' spreads under pressure. On the other hand, if deposit rates are also reduced, fresh collection of funds could take a hit. The RBI has also said in its mid-term review that fixed-income groups, who expect a reasonable inflation-adjusted return, constrain banks' ability to reduce lending rates without affecting their deposit mobilisation and the growth of financial savings. Apart from high cost deposits and non-interest operating expenses, the relatively high overhang of NPAs further pushes up lending rates. The RBI has also asked banks to improve their spreads by reducing operating costs coupled with higher volume of lending.

Outlook
After the initial euphoria, bonds are now expected to be range bound with the benchmark 10-year security moving in the band of 8.75 to 9 per cent. However, there could be another short rally if the RBI reduces repo rates - the markets now widely expect the RBI to pull down the corridor for its LAF by cutting both repo and reverse repo rates. While first CRR cut will add Rs 6,000 crore on November 3, another Rs 11,000 crore will flow into the system with coupon payments and redemption. However, despite the surfeit of liquidity, yields may not take a plunge in isolation. As in the past, the RBI will plug any attempts to pull down yields to unrealistic levels through OMOs and auctions. This could also trigger some volatility.