Bond rally: Another means to offset CRR cost

Written by OP Thomas | Mumbai, Apr 29 | Updated: Apr 30 2008, 06:06am hrs
Government bonds rallied Tuesday after the Reserve Bank of India (RBI) left key policy rates, the rate at which it borrows from and lends to banks in reverse repo and repos, unchanged at 6.0% and 7.75% respectively. By doing so, the RBI has signaled that interest rates are at best stable if not softer.

The hike in banks cash reserve ratio (CRR) by 25 basis points, however, indicated that the RBI was serious about drying up surplus liquidity in the system without disturbing the current interest rates across maturities. CRR the cash banks maintain as a percentage over their net deposits do not fetch any interest and is taken away by the RBI out of the money market. Banks will hence have to find other ways to offset the cost, as any move to pass them on to the end user would have a negative impact on their loan portfolio.

Most bankers had not anticipated the RBI to hike CRR when it already announced a 50 bps-hike in two stages, a fortnight ago, but a few did. Those who didnt expect began to sell the 10-year benchmark bonds in anticipation that interest rates would harden. As a result bond prices began to ease and yields firmed up rather in top gear. A few banks, hence, began building up positions on the basis that interest rates were not to rise even if CRR was raised. From Rs 99.02 (yield of 8.17%) on April 17, the day when RBI announced it would hike CRR by 50 bps, the benchmark 7.99% Government bonds of 2017 topped Rs 100.70/71 on Monday, returning a yield of 8.17%. And on Tuesday, the benchmark bond ended at Rs 102.05 pushing down the yield from a high of 8.17% to 7.94%.

Tuesday, also witnessed the highest turnover of Rs 10,000 crore in the G-secs market, which till the Monday was averaging Rs 2,500 crore.

The latest CRR hike will take away Rs 9000 crore from the system, taking the total to Rs 27, 500 crore by the first week of June.

The bond rally on Tuesday hence was largely on account of two factors: one the building up of positions that started a fortnight ago and secondly, the traders who joined the bandwagon Tuesday. Some way for banks to offset losses on account of CRR hikes.

While the RBI has managed to communicate that interest rates are not seen up in the near future, what it has not considered is the burden of cost that would entail on banks that are giving away 8.25% of their net deposits in cashfree of charge!

Take the largest government bank, the State bank of India, the cash it would be shelling out with every 25 bps CRR hike, is roughly Rs 2,500 crore, which is nearly 28% of the Rs 9,000 crore estimated. With the latest hike, the bank, so far, would have easily parted with Rs 45,000 crore of cash since its inception. The cost of such funds, if calculated at a conservative 5%, works out Rs 2,250 crore or Rs 2,250 crore down the drain.

Given the current scenario of a moderating domestic economy, an overall global slowdown and inflationary pressures due to external factors, the RBI appears to be controlling too many parameters at the same time.

It is controlling the exchange rate by keeping dollar over Rs 40 thereby protecting exporters and increasing the cost of imports, especially when inflation at 7.33% is also on account of commodities and fuel costs; it wants bank credit to go to the housing sector at the same time increase the cost of bank funds.

One therefore wonders whether the RBI is addressing the wrong end of the stick given the fact that the current inflation is best address through fiscal measures than monetary. The least the central banker could do at this juncture is to ensure that bank credits are controlled and directed to the right sector so that commodity hoardings and speculations are prevented. One way is to increase the capital adequacy requirement in key areas so that bank credit to specific speculative sectors like finance against food grain stocks becomes unattractive to banks.

For the moment banks are punished with higher costs of funds and profits are likely to come under tremendous pressure.