An SLR hike will immediately translate into a rise in the demand (from banks) for government bonds, says Abheek Barua.
My colleague, Amit Dayal — astute money manager, foodie and recent convert to gym-ming — has come up with what seems like a pretty smart way to counter the upward pressure on bond yields. But before I get to the specifics of his suggestion, let me start with a bit of a prelude.
In the second half of 2008, the markets viewed expansionary fiscal policy as a deus ex machina that would lift it out of its funk. Ironically enough, as a number of government exchequers obliged by loosening their purse strings and President Obama handed out the mother of all fiscal packages, the market suddenly woke up to the fact that these fiscal steps entailed significant costs.
As governments turned to the bond markets to fund their fiscal binge, bond yields rose sharply and now threaten to stall lending rate reductions. In India, for example, the 10-year bond yield has risen by a hefty 160 bps between the low of early January and the level today. This has been in response to the huge additional government borrowing — Rs 46,000 crore for the current year despite which there is a fiscal hole of Rs 45,000 crore. The government is now filling this hole by transferring money locked up in Money Stabilisation Bonds (MSS).However with the stock of MSS dwindling fast it might not have that option next year. The central government incidentally needs to pick up at least Rs 3,70,000 crore from the market in the next fiscal, going by the calculations in the interim budget.
The fear of government ‘crowding out’ private spending might appear, at least at this stage, a tad irrational. Private credit demand is collapsing as the recession intensifies and government demand is likely to fill the void left behind. Thus neither yields nor interest rates should necessarily harden in the near term even if the government guzzles funds. Should the market rest easy then?
Perhaps not. For any forward-looking investor, the longer-term consequences of a fiscal bloat are difficult to ignore. For one, while it is easy to run up a large deficit very quickly, they are difficult to tame. A large deficit entails high interest costs for the government that feed the fiscal gap leading to more borrowings. In short, the government is likely to remain a large borrower for a good few years if there is a large fiscal overrun now. The implication — whenever private credit demand picks up, the competition from the public sector would push borrowing rates up and stymie growth. This anxiety is getting reflected in high government yields.
Is there a way to handle the increased government draft on resources without pushing rates up? Monetary policy rates at close to zero in the developed markets rule out further rate action; the only option for central banks would be to keep buying back government bonds, which de facto means monetising the fiscal deficit. Amit suggests that the impact of government borrowings can be handled better in India than in other markets. This is essentially because of the unique monetary device that we have called the statutory liquidity ratio or SLR (the fraction of the banks’ aggregate liabilities that they are mandated to hold in government securities). It is currently at 24 per cent.
The crux of Amit’s argument is the following — instead of focusing entirely on shoring up the supply of liquidity to check bond yields, the government might be better off in trying to best push up what he calls the ‘inherent demand’ for government bonds. If there is no inherent demand, he argues, growing supplies of bonds will keep pushing yields up. The easiest way to increase this ‘inherent demand’ is by hiking the SLR. This will immediately translate into a rise in the demand (from banks) for government bonds; as banks are forced to buy bonds, bond prices will move up and bond yields would head down. A 1 per cent increase in the SLR, incidentally, yields additional demand for government bonds of roughly Rs 40,000 crore.
What are the advantages of this somewhat unorthodox strategy? If bond yields come down, the government borrows at a lower average cost. This could dampen the fiscal spiral that high interest bills set off. Banks stand to make marked-to-market gains on their bond books and this could give them a cushion to absorb the costs that could follow from a rise in non-performing loans that are likely to rise in a downturn. The RBI, in its avatar of merchant banker to the government, can push through the government borrowing programme more easily.
A policy involving an increase in the government’s draft on funds in the middle of a slowdown might seem a little counterintuitive. However, if you follow Amit’s logic through, it appears to make sense. For one, the governments will remain the bigger provider of demand in a business cycle trough and the sensible thing to do is to ensure that their access to funds is easy and comes cheap. An SLR increase ensures this.
Are banks likely to worry about the impact on liquidity that a hike in SLR entails? Could this affect the flow of credit to the non-government sector? The way around this, Amit argues, is to provide refinance to banks against the entire additional stock of SLR that they need to hold. If liquidity does tend to tighten a little, banks can turn to this window to access liquidity. The refinance could come at the repo rate. If the RBI wants to signal lower cost of funds, it needs to cut the repo rate.
What happens as the economy starts picking up and private borrowers need more credit? The RBI would have to reduce SLR to accommodate this and this could potentially spike yields up. Amit accepts that while this could potentially lead to marked-to-market losses on banks portfolios, there could be a few offsets. Economic recovery is likely to coincide with an improvement in government finances. If indeed the government borrows less incrementally, the impact of a reduction in SLR on bond yields need not be sharp.
Amit mailed me a note on this titled ‘Wild Thoughts’. Perhaps his thoughts are not so wild after all. I wonder what Dr Subbarao would have to say.
The author is chief economist, HDFC Bank. The views here are personal
