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Banking On RBI

Bonds gained marginally this week. Everyone is hoping that the RBI will reduce the bank rate, which will ignite a fresh rally in the wayward bond market. But if that doesn't happen, there could be a sell-off in the market.

Expectations abound this week. Anticipating an announcement of bank rate cut in the credit policy, bonds gained marginally this week. The government's decision to privately place the bond with RBI kept the bond prices rising. Consequently, the yield on the 10-year benchmark (11.03%, 2012) dipped to 7.28% on Thursday from Monday's close of 7.34%. Market opened lower on Friday hoping that the Finance Minister may rollback the small savings rate cut as proposed in the Budget. But since he didn't, bond prices rose by 10-15 paisa. The yield on the benchmark finally closed at 7.29% – down 4 basis point over the week.

On the forex front, the rupee plunged to an intra-day low of 49.06/$ on Wednesday, but bounced back to end the week at 48.97 saved by public sector banks who sold dollars in the market to prevent rupee from plunging further. As for call market, it remained firm this week. Since this was the first week of the reporting Friday and banks had already covered their cash reserve ratio (CRR) requirement, there wasn't a huge demand for funds. Hence, call rates remained in the 6.35-6.70 bandwidth throughout the week.

In an interesting move, finance minister Yashwant Sinha partially rolled back some Budget proposals. Tax exemption limit under section 88 has been increased to 15% for people in the income slab of between Rs 1.5 lakh and Rs 5 lakh. This was reduced from 20% to 10% in this year's Budget. Further, the ceiling on such savings has been raised from Rs 80,000 to Rs 1 lakh and a 5% service tax proposed on life insurance premium has been done away with. Also, 4% excise surcharge imposed on certain goods has been rolled back. All this is expected to cause the exchequer a loss of Rs 2,150 crore.

Since the FM hasn't rolled back the small savings rate cut, the market is expecting a 50 basis points reduction in the bank rate. The RBI is also likely to bring down the CRR from 5.5% to 3%, although in phases. In October last year, the RBI had reduced the bank rate by 50 basis point and the CRR by 2 percentage point, releasing another Rs 8,000 crore into the system. However, today, situation is different, since already excess liquidity is floating in the market. So, even if RBI reduces CRR by 50 basis point, it will be followed by an open market operation to suck out excess liquidity.

However, a cut in the bank rate will help banks gain access to cheaper re-finance. Which, in turn, will mean banks may reduce the lending rates. This is likely to enthuse the Indian corporate sector. Besides, a drop in interest rates is in line with the policy of maintaining a softer interest rate regime. This will not hurt the commercial banks much though their earnings may be hit as a result of lowering of lending rates. But economic revival will help banks recover dues from corporates and thereby bring down their NPAs.

Now, the ball is in the RBI's court. If the much-expected bank rate cut is, indeed, announced it will ignite a fresh rally in the wayward bond market and enhance capital gains for bond and gilt funds. While call rates have momentarily firmed up, it is unlikely that RBI would go in for liquidity tightening at this juncture. Also, there is no auction scheduled for the week. On the other hand, if the rate cut fails to materialise, there could be a sell-off in the market. So, over to you Mr. Jalan.