Pressure of Govt. borrowing on interest rates

By Oommen A. Ninan

MUMBAI, JULY 21. With the bottoming out of interest rates, the Government securities (gilts) market is headed for a consolidation. Market participants also believe that with the fast pace of the Government's borrowing programme, interest rates may firm up in the medium to long term.

The securities market had witnessed high volatility at the beginning of this fiscal in general and during the last few weeks in particular. With the recent unprecedented fall in the yields of Government of India securities in expectation of a Bank Rate cut in tandem with the U.S. Fed interest rates have softened. As a result traders have taken large positions at higher prices (implying lower yields).

However, market participants with huge trading positions were caught unawares last week by the auction announcement of Rs 5,000 crore worth of securities from the Reserve Bank of India's own stocks (open market operations) and the candid statements made by its Deputy Governor, Dr. Y.V. Reddy, delinking any direct relationship between US Fed rate cuts and cuts in the domestic bank rate.

``In a bid to cool the gilts market the central bank conducted the open market operations (OMO) auction of the 12.59 per cent 2004 security,'' said Mr. Sanjeet Singh, Head of Research, ICICI Securities. With the liquidity position in the money market being comfortable and the security being at the short end of the yield curve, the sale received good bidding interest of Rs. 8,415 crores and the central bank managed to offload the entire stock of Rs. 5,000 crores. The auction cut-off was at Rs. 112.25 (7.83 per cent YTM). Said Mr. Singh, ``Probably disturbed by the sharp rally, which saw historic highs almost every day, the Central bank conducted the OMO sale to suck out the excess liquidity. The statements of the Deputy Governor amplified the impact of the OMO and in a span of two days, the long-end prices fell by around three rupees temporarily.''

The combination of these factors resulted in the market heading for a crash as the sentiment turned negative. The yields touched historic low levels and the benchmark ten-year yield came down to around 9.30 per cent. The RBI Governor has been stating repeatedly that the interest rates are softening. In fact this has been happening over a period. The yield on ten-year Government paper eased from 12 per cent in March 1999 to 10.85 per cent in March 2000 and further down to around 9.30 per cent in July this year which is a historical low level.

``Markets are consolidating after the volatility we saw last week in the Government securities market. Yields are expected to consolidate at current levels of 9.50 to 9.60 per cent for ten- year securities. Going forward, yields are expected to be stable with the market liquidity being comfortable to absorb any impending supply from the Government,'' said Mr. V. Srinivasan, Head of Markets, J P Morgan.

However, another school of thought believes that the rates will move to 9.75 per cent as the Government's borrowing programme progresses and credit picks up in the busy season. The sovereign borrowing programme continued its frentic pace with further Rs. 7,000 crores of dated securities getting issued during the past fortnight. By the first half of July, around 59 per cent of the budgeted dated issuances have been completed as compared to just 38 per cent last year.

The Government borrowing programme is expected to gain momentum on account of a significant shortfall in revenue collections and a delayed disinvestment programme. Moreover, the Finance Minister has been exhorting the public sector undertakings and government departments to speed up investment as planned in the budget proposals, in order to speed up economic growth. The net result of all these could be higher Government borrowings in the coming months and hardening of interest rates.

The investors in government securities are largely banks, insurance companies, provident funds which find the current yield level very unattractive. However, with a lack of other investment opportunities, the funds are diverted to the gilt (government securities) markets. With deposit rates already at low levels banks may not be in a position to reduce interest rates further. The reduction in the yield on investments has considerably eroded the spread between cost of funds and yield on assets. So, any further reduction in yield will adversely affect the profitability of banks.

A cut in Bank Rate at this juncture would have further reduced the yields. It is not necessary that when the rate of interest goes down advances will increase automatically. The growth in advances is largely dependent on availability of viable investment opportunities and demand for credit arising therefrom.

With good monsoons, credit offtake is expected to go up in the busy season which may result in reduction in liquidity in the market which can push up interest rates.

If such a scenario emerges, the RBI has various instruments in its armoury to infuse liquidity in order to ensure that the productive sectors of the economy are not faced with liquidity constraints.

The market cannot expect RBI officials to give their views on day to day movement of interest rates. This results in participants going on buying securities with speculative intentions bringing down the yield very low which cannot be supported by the fundamentals of the economy. In the light of a significant fall in revenue collections and Government's frenzied borrowing one wonders where interest rates are finally headed.

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