Increased pressure on banking sector

Ideally, a bodybuilder pays equal attention to every part of the body. But some focus on biceps and forget about their legs and end up with big arms and spindly legs. India's financial economy has seen this sort of imbalanced development. There is a vibrant stock market with many liquid stocks traded, and wide coverage across sectors. But the bond market - the market for debentures and other debt instruments - is much less developed.

Debt market action is dominated by the auction of government treasuries. There is little secondary trading of those instruments. Very few corporate bonds are floated and, again, there is no secondary trading to speak of. This has many negative consequences. One glaring problem is it becomes expensive and difficult for companies to raise long-term debt. This really hurts infra projects with long-gestation needs. For example, a developer building a road needs long-term funding. The road makes no money until it is functional and tolls are levied. Ideally, debt must be raised with a tenure of 10-15 years.

Lenders find it hard to provide that long-term funding. Banks borrow cash at much shorter tenures and there are major asset-liability mismatches. If a secondary debt market existed, projects could raise this money more easily through debenture issues. Debenture subscribers would be able to exit at need simply by selling the bond and the asset-liability mismatches would smooth out.

Even other companies, who don't need such long-term funding, would find it easier to raise debt, if there was a secondary market. There is an interest spread between the rates at which banks borrow cash and lend cash. A liquid secondary bond market reduces that spread.

Illiquidity also introduces distortions and makes price discovery uncertain. In theory, every change in interest rates should be reflected by changes in prices of debt instruments. If interest rates fall, the price of bonds issued earlier at higher interest rates should rise. Vice versa, a rise in rates should mean falling prices for bonds issued earlier at lower interest rates.

Again, in theory, the yield on a long-term instrument should usually be higher than one on a short-term instrument of comparable safety. This means a long-term bond should be priced lower than a short-term one.

The yield curve flattens out, or inverts, when long-term instruments are priced relatively higher than short-term. When this happens, it indicates something unusual, like market expectations that interest rates will push higher.

Policy rates have reduced by 75 basis points in 2015. This should have been reflected in dropping yields across the board. The bulk of the bond market consists of government debt, so the instruments are comparable and safe. Since the start of June, when we saw a rate cut, treasury yields have actually risen in long-term bonds. The yield on the old 10-year benchmark was at 8.09 per cent last week, close to what was seen in November 2014, when policy rates were 75 basis points higher. The new 10-year bond was at a yield of 7.88 per cent.

According to an analysis by the website Capitalmind.in, banks could lose a lot of money if this situation continues and the yield curve steepens more. Banks must hold a certain amount of government paper as part of the Statutory Liquidity Ratio - government bonds are considered cash-equivalent. In practice, banks hold much more government debt than required under SLR. Foreign Portfolio Investors (FPIs) were also holding large amounts of treasury debt. (FPIs can only hold long-term debt.)

At least in theory, prices should have risen for all bonds, as policy rates fell. But there has been FPI selling, which might have influenced the trend of falling long-term bond prices. In the circumstances, banks will take big 'Marked to Market (MTM, revealing securities at current prices)' losses on excess bond portfolio. They may actually book some losses because they may not be able to hold everything until maturity and an illiquid secondary market makes it hard to absorb supply. Falling long-term bond prices could also indicate some disappointment with the Reserve Bank of India (RBI)'s stance. The central bank has indicated it will play a waiting game and wait to see what the US Federal Reserve does and for clarity on the monsoon. Ideally, regulatory authorities like RBI and the Securities and Exchange Board of India would get together with the finance ministry and try and energise the secondary bond market. There doesn't seem to be much chance of that happening in the foreseeable future. So, be braced for banks to declare a bad quarter due to MTM losses on their bond portfolio. This could lead to increased bearish pressure on the banking sector.