Has the 2009-10 Budget put the banking industry on the back foot? Seems to be so! The economy may be recovering, but bankers think they are entering uncharted territory. During 10 months they have already brought their deposit and lending rates down, thinking that it would give rise to a spurt in credit offtake and good earnings. But things did not happen as planned. The credit offtake continues to be weak and at the same time large fiscal deficit and consequent large government borrowings are now expected to turn the table on interest rates. Since October, the Reserve Bank of India (RBI) has cut the repo rate by 425 basis points to 4.75%, the reverse repo rate by 275bps to 3.25% and banks? cash reserve ratio by 400bps to 5.0%, in a bid to revive the slowing economy.

A report by Edelweiss Securities has pointed out that the maiden Budget of the re-elected government has given priority to GDP growth over fiscal prudence. With fiscal deficit for 2009-10 pegged at 6.8%, and the announcement of certain tax relief measures (accompanied by the impact of slowdown on tax collection), capital receipts are expected to bear the burden to finance 39% of the mammoth Rs 10.20 lakh crore expenditure. It is expected that the RBI, which has already sold Rs 1.62 lakh crore in the first quarter of 2009-10, will flood the market with additional Rs 2.89 lakh crore, issuing Rs 4.51 lakh crore of dated securities for 2009-10.

Further, while the central government is set to borrow Rs 4.51 lakh crore, state-governments, already facing fiscal slippage, are likely to borrow Rs 1.61 lakh core, taking the cumulative sovereign debt issuance for dated securities to at least Rs 6.12 lakh crore.

?Most participants were anticipating market-borrowings in the range of Rs 4.0-4.15 lkah crore. However, with the actual borrowing being much higher than what the bond prices had factored in, we justifiably witnessed an immediate sell-off,? said the report. Pending clarity on how the additional borrowing will be scheduled and financed, over near-term the money market expects choppy trading sessions and the 10-year to trade in the range of 6.80%-7.35%. Also, overriding bearishness will keep volumes low as any softening of yields will be seen as an exit opportunity. Regarding the non-SLR segment, the research house said that it anticipated the market to lose its sheen in the near term. While it is unlikely to witness any major sell-off from the current levels, it is expected that 5- and 10-year yields to test 8.15% and 8.75%, respectively, in the near term. Plush liquidity will suppress short-term rates and the upside momentum will only be on account of alignment with the overall curvem said the report. As inflation turns positive and excess liquidity tapers off, the short-end (1-year CDs) is expected to react much quicker than the 5- and 10-year.

The money market now expects the short term rates to 6% for CD 1-year with the premium on CP of 100bps with a downward bias, and 8.50% and 9% for the 5- and 10-year bonds respectively over next 6-months. ?We anticipate the on-going sell-off to recede from current levels; any softening in yields from current levels will be a function of clarity on the management and financing of the mammoth borrowing program,? concluded the report. However the government has asserted that it does not intend to resort to monetisation of its debt, which means direct borrowing from the RBI, to fund widening fiscal deficit, pegged at 6.8 % of GDP this fiscal.

The government, through a release, also clarified that the RBI?s open market operations (OMO), through which it releases or sucks excess money from the market against government securities, are not monetisation of its debt. However, there were speculations that part of this borrowing would be through open market operations, which many said was monetisation of debt. It is this impression, that the government tries to dispel. ?It seems that the OMO of the RBI is being confused with monetisation. The government has clarified that the OMO of the RBI is a regular tool for effective liquidity management… The RBI can either buy or sell government securities in the secondary market as part of its OMO,? the official statement said.

Monetisation of the government debt would be when the RBI directly subscribes to the government paper. However, the government said that it did not have any proposal to do so, even as the FRBM Act empowers it to do so under some circumstances. ?There is no inherent contradiction…between the monetary policy and the fiscal policy. We are working closely as we have done in the worst period of the present crisis,? finance minister Pranab Mukherjee told reporters after a customary post-Budget meeting with the central board of directors of the RBI. Mukherjee assured that the government?s borrowing programme would not crowd out private investment.

Global rating agency Moody?s threatened that India?s ratings may be downgraded if government debt rises substantially, due to a lack of medium-term reforms and delay in privatisation among others. ?… if the Indian government?s debt finance-ability and its debt sustainability were to worsen ? due to a lack of medium-term reforms or delays in privatisation, or due to large unexpected shocks?- then negative rating actions may follow,? Moody?s vice-resident and senior analyst Aninda Mitra said. Maket analysts have said that after looking at the latest trend in the industrial production numbers and the pressure on inflation on a week-on-week basis, we feel that the rate-cycle has already bottomed and that the RBI will maintain status quo in its monetary policy review on July 28. However, the RBI may not be in a position to increase the policy rates during the calendar year even as inflation could be expected to rise on account of food and fuel related shocks. This is due to the uncertainties still remaining in the global financial system and also due to a likely fall in rural demand due to risks from monsoon. Any removal of monetary accommodation, in this sense, could be pushed away to April -June 2010. However, it is possible for the RBI to move to a neutral zone or moderately hawkish stance by end of Decemeber to prepare the markets for a reversal in easy monetary policy

?The challenge for the Reserve Bank will be to create the stage for a 9% growth in an environment of price and financial stability … Our negative inflation does not reflect a demand constraint …,? RBI governor D Subbarao said in an interview with Central Banking Publications, London. He said that inflation in the negative zone has triggered speculation about further rate-cuts, but the central bank takes into account many indices including the wholesale price index and four indices of consumer price index. ?We also look at the inflation expectations survey that we do. So I want to reiterate that the current temporary negative inflation is not structural in nature, but rather it is only statistical,? Subbaro added. ?We think the government-borrowing programme will go smooth. Currently, there is ample liquidity in the system and the credit offtake of banks is still very low. However, there could be some hardening of interest rates by maybe 25 basis points,? noted a top official with a public sector bank.

India?s wholesale price inflation has been in the negative zone for four weeks in a row, but its consumer-price counterparts are still very high, presenting a dilemma for the RBI to go for rate-cuts or not. Subbarao, who has been applauded for reversing the tight money policy after becoming the governor in September 2008 to tackle the economic slowdown, will face the real market test now by proving whether he can sustain it in the long run.