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The Reserve Bank of India (RBI) on Tuesday signalled a partial relaxation in its tight money policy, adopted a month ago. In a move to comfort the government bond market after a sharp spike in long-end yields, the central bank has decided to infuse liquidity into the market.
As the liquidity infusion will be in the long-end, while a tight money policy will continue in the short term, analysts termed the RBI move an Indian version of the US Federal Reserve's 'Operation Twist'. In September 2011, the Fed performed Operation Twist in to reduce long-term interest rates. In this operation, Fed sold short-term treasury bonds and bought long-term ones, pressuring the long-term bond yields downwards.
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The RBI move is aimed at cooling the domestic bond yields, which have risen about 190 basis points since the liquidity-tightening measures were announced on July 15. RBI's latest measures came on a day that saw the Indian currency breaching the 64-a-dollar mark but managing to cut losses on intervention from the central bank.
| CHANGING TACK |
To ease pressure on liquidity & money market rates, RBI will
To soften blow on banks’ books due to rise in bond yields,
|
Market players expect a sharp rally in bonds and its rub-off effect on the rupee when the market opens on Wednesday. The expectation is that the yield on the 10-year benchmark government bond will slip under the 8.50 per cent level. Banking stocks are also expected to rise sharply.
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RBI said it would buy long-dated government bonds worth Rs 8,000 crore through an open-market operation on August 23 and, thereafter, decide on the amount and frequency as warranted.
In a breather for banks, RBI also relaxed rules on mandatory bond holdings, known as the statutory liquidity ratio (SLR), which will help them protect their bond portfolios from large mark-to-market (MTM) losses.
In contrast with an earlier rule asking banks to reduce their hold-to-maturity (HTM) bond holdings gradually to 23 per cent of deposits, RBI has now allowed them to retain those holdings at 24.5 per cent of the total. "The hardening of long-term yields has resulted in banks incurring large MTM losses in their investment portfolio," RBI said.
On July 15, RBI had increased the marginal standing facility (MSF) rate by 200 bps to 10.25 per cent and capped banks' borrowings under the liquidity adjustment facility (LAF), along with sale of government bonds, to tighten liquidity. As a result, short-term rates increased to the MSF rate. RBI decided to maintain the MSF rate at 10.25 per cent, indicating it wanted short-term rates to stay high to curb speculation in the currency market.
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The collateral damage, however, was in the bond market, which saw yields jumping to 9.48 per cent (intra-day) - by almost 200 bps since the start of the quarter. The rise in bond yields hurts the government's borrowing programme, besides forcing banks to provide for MTM losses.
Though the central bank did not cut the MSF rate, on Tuesday it softened its tone considerably. It said: "It is also important to ensure liquidity tightening does not harden longer-term yields sharply and adversely impact the flow of credit to the productive sectors of the economy."
"The steps taken by RBI today should not be seen as a complete reversal of liquidity-tightening measures. The central bank adopted a trial-and-error method, as the situation was not completely in its control. It has responded to the evolving situation that has seen a huge spike in bond yields, which, going by the fundamentals, is unjustified," said HDFC Bank Chief Economist Abheek Barua.
Markets might have sniffed what was coming, as bond & currency markets, as well as the equity market, rebounded from day's lows.
"While these corrective measures send out the right signal to the bond market, some time will have to be given to the earlier measures for the rupee to stabilise. Meanwhile, the higher short-term yields should attract foreign investors & non-resident Indians. These yields make for an attractive reason for exporters to sell their forward dollars," said Paritosh Mathur, head of fixed income and currency trading, Deutsche Bank India.
Investors also noted the stress with the BSE Bankex shedding 31 per cent since May 17 (the 2013 high for the index). The Sensex fell 10 per cent during the same period.
According to analysts, a 100-bp rise in yields on government bonds will lead to roughly Rs 33,000-crore MTM provisioning in a quarter - almost double the combined first-quarter profit of all banks (of Rs 19,849 crore), or close to half their full-year profit of Rs 77,045 crore in 2012-13.
The rupee might also gain from the moves, as inflows in the equity market might release the pressure from the currency.
"It won't be surprising if the 10-year bond yields cool off to the 8.3 to 8.4 per cent level. If that happens, it will be very positive for banks, which had taken a bad hit on account of MTM losses due to rising yields. There will be a sharp pullback in the bank stocks on Wednesday and the overall market will also be positive, given the high weight of financial stocks," said Nitin Jain, president (retail capital markets), Edelweiss Financial Services.
CHANGING TACK
To ease pressure on liquidity & money market rates, RBI will
|buy bonds via OMOs to infuse Rs 8,000 cr on August 23
|lower quantum of cash-management bill issuance
To soften blow on banks' books due to rise in bond yields,
|the rule to cut SLR bonds held in HTM book to 23% has been kept in abeyance; banks can retain SLR bonds in HTM at 24.5% of net deposits
|banks can move SLR bonds from available-for-sale (AFS) HTM bucket at July 15 values
|depreciation due to MTM valuation for AFS/HTM securities can be spread over equal instalments in 2013-14
