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Rally Revives on Jalan Speak

Government can overshoot borrowing target as industrial slump impacts revenue collection

The FITCH-snapped rally again took wings this week on the back of Jalanspeak and subdued call rates. RBI governor, Bimal Jalan again expressed his concern on the slump in industrial production and reiterated the apex bank's stance to maintain soft interest rates. This lifted hopes for an interest rate cut and triggered a rally in gilt prices. The market now awaits firm action on interest rates from the central bank. The sentiment was also buoyed when Moody's declined any downgrade of sovereign rating. The rupee ended flat after slipping a tad on Wednesday due to heavy dollar purchases.

Liquidity was comfortable during the week since most players had covered their positions ahead of the reporting Friday. There was an attempt by lenders to artificially perk up call rates but could not sustain them due to abundant supply. The three repo auctions attracted a subscription of Rs 11,500 crore while there was a lone reverse-repo for Rs 100 crore.

There are concerns that government's revenue collection may fall short of the targeted amount due to the current slowdown. This could lead to additional borrowing and put pressure on fiscal deficit unless the government finds alternative means to generate inflows. While divestment of PSUs has long been on agenda, the government needs to repeatedly display a firm commitment, as seen during Balco negotiations. However, this seems to be a tough task now, given a weak government and impeding elections in the crucial state of Uttar Pradesh in early 2002.

Outlook
Call rates are expected to firm up next week under the impact of advance tax outflows. An auction announcement is also expected since the last sale of government bonds was conducted for the week ended June 2. The RBI has so far completed nearly 40% of the government's borrowing programme while the usual target is to raise 70% by end of September. Thus, the RBI has to mobilise another Rs 36,000 crore in the next 14 weeks with most auctions concentrated at the longer-end of the yield curve.

While the market has already factored in a 50-basis point cut in bank rate, yields are unlikely to dip significantly from current levels. Thus, some players have been buying corporate bonds with similar maturities to pick up yield. Participants have also been building positions in the 6-10 year gilts' segment, where the yield curve is steep with favourable risk-reward ratio. On the other hand, there is little activity at the longer-end with a sharp decline in yield spread.

The FOMC meeting is scheduled for June 27 and consensus is building for another 50-basis point cut in interest rates. Apart from demands of a slowing economy, a rate cut in the US will put additional pressure on the RBI. Thus, a reduction in bank rate seems to be in the offing.