SLR demand may squeeze gilt supply

The government securities market is likely to witness a demand-supply imbalance in the next couple of quarters, as a healthy growth in deposits is expected to drive up banks' demand to meet statutory requirements.

Many banks' statutory liquidity ratio (SLR) investments dwindled close to the minimum required 25 per cent from highs of nearly 40 per cent about three years ago. These banks would now mandatorily be required to make the regulatory investments as their deposits grow.

A serious demand-supply imbalance could ensue in the government bond market if demand from insurance firms and provident and pension funds continues to be robust, debt analysts said.

"Our analysis shows that the complications caused by falling SLR holdings are serious enough to warrant a re-look at the SLR provision. In the absence of any move to reduce SLR, bond yields may continue to remain divorced from fundamentals, thereby hampering the monetary transmission mechanism," said ICICI Securities in its special report on SLR.

Analysis shows that banks' SLR demand may account for 75-100 per cent of total issuances in 2007-08, should deposits continue growing at the current pace and banks' maintain their SLR at 27-28 per cent.

Given the incremental demand from other large investors such as insurance firms and provident funds, such a situation portends a serious demand-supply mismatch in the bond market leading to sustained downward pressure on bond yields.

The Reserve Bank of India (RBI) does not have many options to correct emerging imbalance as an amendment to the Banking Regulation Act is still pending.

The amendment, introduced in parliament in May 2005, seeks to provide RBI with the flexibility to notify SLR between 0 per cent and 40 per cent, but it is stuck due to disagreement with some alliance partners on some other provisions.

"Going by the extant SLR requirement, our projections show that in the current year, banks' purchases are likely to account for 57.2 per cent of net issuances, a significant rise from the 11.4 per cent trough in 2005-06. The fourth quarter is likely to see higher demand with banks' purchases accounting for 61.7 per cent of planned issuances. The figure may rise sharply to 93 per cent in 2007-08," ICICI Securities said.

S P Prabhu, head of fixed income at IDBI Capital Market Services, said "There is no panic at least in this quarter. If the amendment to the act gets passed in the budget session, then the RBI will have flexibility in adjusting the banks' SLR requirements. A reduction in the SLR in the next fiscal might become essential."

There is also likely to be excess demand from banks as they seek to maintain their SLR holdings comfortably above the minimum required, with many of them recently having had to borrow overnight money at exorbitant rates from the call money market. Borrowing at such high rates could have been avoided if banks had enough securities to tap RBI's liquidity adjustment facility.