The Reserve Bank of India (RBI) cut the repo rate on January 15, 2015, from 8% to 7.75%, and since then has brought the rate to 6.75%. A major concern of RBI is that the benefit of reduction in rates has not been fully transmitted to the customers by banks. Since the first repo rate cut in January 2015, the State Bank of India (SBI) has reduced its base rate by 70 basis points (bps) against a 125 bps reduction in the repo rate.
That is because banks rely mainly on term deposits and CASA (current and savings bank accounts) for their resources. A reduction in term deposit rates, when the repo rate is reduced, takes time to translate into the cost of funds, as repricing at a lower level for existing deposits takes place only at the time of maturity.
While there has been a partial transmission in case of banks’ customers, the largest borrower in the economy, the government both central and state levels has not had any significant reduction in its cost of borrowing. The government borrows from the market by issuing bonds of various maturities. The major subscribers to these bonds are banks, insurance companies, provident funds, pension funds, mutual funds, corporate, etc. Bond prices are market-driven, unlike bank loans. Theoretically, a reduction in repo rate should be immediately transmitted to the bond price. However, this has not always been the case, and particularly now. While the repo rate has come down by 125 bps since January, the yield on a 10-year benchmark government bond (G-Sec) has reduced only by 12 bps from 7.88% on January 1, 2015, to 7.76% on December 4, 2015. The chart indicates that though there has been steep reduction since January 15, the yields have remained flat or have gone higher.
Unlike in the case of a commercial unit, interest payments on borrowings is a large component of government expenditure. The current year budget estimates an outgo of Rs 4,56,145 crore on account of interest payments by the Union government, mostly on market borrowings, which is a very big part of the planned expenditure and 70% of total gross borrowing. Currently, with the economy in doldrums, the government is looking to provide a fillip by increasing its investments. Thus, the need for lower rates for the government is obvious.
However, there are more reasons for us to be worried about the lack of transmission to bond yields. A high yield on G-Secs affects banks in two ways—on the deposit side with a risk-free government bond yielding 7.76%, banks do not have much elbow room to bring down their deposits rates, thus restricting their ability to reduce lending rates. In an increasing interest rate scenario, banks earn higher profits in the banking book with higher net interest margins (NIMs), as the increase in the cost of deposits is felt with a lag, but book losses in the treasury where the mark-to-market value of securities comes down. The opposite happens in falling interest scenario. However, with yields remaining stubborn as at present, the room for treasury gains is limited. Also, with attractive zero-risk yields in government securities, there will be no incentive for banks to finance risky loans at fine prices. High yields are also a deterrent to the corporates, who would like to access the corporate bond markets as corporate bond prices depend on G-Sec yields. So, the current situation, where bond yields have not moved sympathetic to repo rate reductions, has been detrimental to all players in the economy, with particular severity on the government.
So, it is in the overall interest of the economy to harmonise monetary policy stance and bond yields. But why the divergence in bond market? With the reduction is SLR and HTM cap for commercial banks over a period of time, the demand from banks for G-Secs has tapered. Provident funds have diversified their investments to corporate bonds and equity ETFs, thus further reducing demand from G-Secs. On the other hand, the supply has been very high in comparison to the liquidity available in the system. In October alone, the issuances amounted to more than Rs 75,000 crore. The possibility of Special State Development Loan issuances beyond their planned borrowing under the Project UDAY—to restructure the discoms—will further increase supply. The last straw is the tightness in liquidity.
RBI’s recent announcement of OMO purchases and infusion of extra liquidity will, to some extent, address the liquidity issue. However, a one-time intervention may not be sufficient because over the next few months the market liquidity will continue to be tight as the government tries to keep a check on its fiscal deficit and the credit pick-up increases. Also, with the volatility in the forex market, RBI may need to intervene by sale of the dollar, further aggravating liquidity tightness. RBI should intervene in the bond market also to curb volatility as it does in the forex market. Continuous presence of RBI in the bond market in addition to regular liquidity infusion and OMOs will help the market behave in an orderly fashion and ensure proper transmission.
The author is MD & CEO, SBI DFHI Limited. Views are personal