RBI’s Intervention in the Government Securities Market

RBI’s intervention in the foreign exchange market is pretty well known but is quite elusive in the government securities market. A recent data from RBI showed that they bought around 1100 Crores of G.Sec by intervening in the secondary market. An intervention in the foreign exchange market is usually to limit the strengthening rupee so that it does not pinch the exporters; the other is of supporting a depreciating rupee which is not done as often as the former is. In case of government securities the intervention is to stabilize shooting yields, as the cost of borrowing is a significant part while deciding the amount the government will borrow in a fiscal year. There are levels beyond which the government won’t be comfortable borrowing, these levels might be known to RBI or made known to them time to time and it is then the dealing room of the Financial Markets Department of RBI comes into action.

Some 7 to 9 months back (not sure about the exact time) there was a time when the 10 year G.Sec yield used to go beyond 8.00 % levels and then come down. The newspapers use to say that the high yields attracted investors, which you can trust once but not every now and then. It was then I was told by a senior veteran of the markets that it’s RBI intervening and not letting the yields go significantly above the 8.00 % levels.

The Indian G.Sec market is a highly news & comments driven market rather fundamentally driven will be a more apt description. Whereas, in our equity markets if one hedge fund decides to buy or sell due to excess or shortage of funds the result is something which defies all news flow or fundamentals on a given day. A recent comment by a MoF official that yields above 8.25% on the 10 year are not justified, was a signal of the levels above which the government won’t be comfortable borrowing. The RBI data showing GOI bonds being bought by RBI points out to the importance of such statements and are helpful for future course of actions as well. The frequent auctions of cash management bills reflect that the government is over-drawing from their WMA from RBI. On top of that the government is borrowing 2.5 lakh crores in the April to September period out of a total borrowing of around 4.17 lakh crore, if this slightly front loaded borrowing is done at high yields it will certainly hit the government badly a time when it’s trying not to borrow more than what they have said.

The market is expecting RBI to stop the rate hike cycle as the growth shows a slight slowdown but inflation has not peaked out completely, the RBI will be more concerned about inflation than growth. Even the government will wish to see the inflation come down as there will be elections soon in some major states where you can’t talk growth numbers as people will be concerned only about rising prices. There is a possibility that RBI might leave policy rates as it is this time and give a 25-50 bps hike if required in the next review according to the IIP and Inflation numbers in coming months. This rate hike pause can be due to the increasing pressure from banks, as the credit growth is sluggish (very less new disbursements) and the deposit growth being robust. This deposit-credit growth gap is a positive for government securities market but will affect banks margins.

The more prudent approach will be to continue with the rate hike as it’s more of demand side inflation now rather than the supply side and brush away the banking sectors concern of credit growth etc. It will be interesting to see what the RBI does as a rate hike and RBI’s stance (which has been hawkish so far) will certainly push the yields above the governments comfort level of 8.25%.

The Inverted Indian Yield Curves

The yield curves are one of the most interesting and sought after information/direction provider for dealers, analysts and economists in particular. Liquid yield curves of countries such as of the United States serves as a leading indicator of the state of the economy and is used for various analysis by economists.

The Indian yield curve is an illiquid curve, it is liquid only at some specific tenor points, like the G-Sec curve at present is liquid at tenor points 7, 10, 11 years and semi-liquid at 5, 16 and 30 year points. Among the Indian swap curves only the OIS curve is liquid and that too at only three tenor points, i.e. 1, 2 and 5 years.

For quite some time now the Indian G-sec curve has been inverted at 5y-10y (a spread of around 10 basis on an average), which reflects that the market is worried about inflation and liquidity in the shorter to medium term but does see inflation cooling with time and expects the growth also to slowdown, which was recently supported by the lower GDP growth numbers. From the current hawkish stance of the RBI it is pretty much clear that the central bank is ready to sacrifice growth in order to tame inflation. Inflation on the other hand is at elevated levels due to high oil and other commodity prices, which are bound to come down once the effect of QE3 subsides. A faltering U.S economy, an inflation struck Chinese economy and a debt ridden Europe signals towards cooling of commodity and oil prices. These signals can eventually lead to an overall slowdown in the global economy; it will again be a challenge for emerging economies to handle volatile capital inflows in such a scenario, given that the emerging economies are not battling with high inflation even then. There is also a possibility that there might be no volatile capital inflows in the emerging markets in case of a faltering U.S economy and Europe problems, as the last time QE3 was a major driver of the inflows coupled with low interest rates in the developed economies. It will be interesting to see how the future unfolds, will we have a QE4 from the Federal Reserve’s in case the U.S recovery falters further and where will the hot money flow, are questions best answered by economists I guess.

Coming back to yield curves the Indian OIS swap curve inverted recently, the 1y-5y swap rates have had a spread of around 5 basis. This was mainly because of an expectation of short term rates rising dramatically due to advance tax outflows, as daily liquidity is already in the negative 50-60K Crs according to the LAF window. Also, the 5 year OIS rate has dropped more than the bond yields have, which shows that there are people willing to receive a swap. When a person is willing to receive a swap in layman terms I infer that one sees interest rates coming down, which again supports the G-Sec yields as they reflect a lower inflation(lower crude prices), growth number and hence lower interest rates in future. Also the global picture of a slowdown justifies the flurry of people ready to receive an OIS swap in the long term and pay a swap in the short term.

Kindly do post your feedback as I have written some “financial gibberish” which needs to be refined.

The solution…………………………………..

To be honest even I don’t know what the solution to the problem I posted is.  As some people have said that I should only go on and give the solution. So here  I am doing some loud thinking which might result in something gibberish, but I dint name the blog Financial Gibberish for nothing (I have the liberty).

The first and the most obvious point is to build more reserve capacity which I guess has already started as the oil ministry has proposed to built a capacity of 1.33 million metric tons at Visakhapatnam on the east coast. The nation’s storage capacity will rise to 5 million tons when two more terminals are built at Mangalore on the west coast by 2012. That’s equal to two weeks of current imports. Still we require more such capacities to be built as a 60 days reserve will serve as a decent cushion considering India’s dependence on oil imports. I would also like to stress on the point that these reserves will help in times of such geopolitical issues where supply could be interrupted.

The other serious issue which needs to be addressed is the liquidity part. The oil imports suck out the liquidity in the Indian markets, as to buy oil the oil companies have to pay in dollars which they get in exchange of rupees. Consider the present situation of our banking system, we are somewhere in the negative Rs.80000 Cr to Rs.1 lakh crore when it comes to liquidity on a daily basis. Imagine what impact huge oil imports will have on this present state, the imports will not only be very expensive but the call rates, volumes in the LAF window and bond yields will jump significantly in order to fund the oil companies. The solution to this is open for discussions as I have no clue at the moment.

The only suggestion I have is that oil companies should not buy oil from the spot market so frequently and should book commodity futures/forwards in the international market (which they are allowed to book with a bank) and hedge the currency risk with a forward (again this is allowed to them with a bank). I have been told by many bankers that corporate usually don’t book oil forwards forget hedging the exchange risk by booking usd/inr forwards. The reason which they usually give is what if the crude prices fall in future and we would have locked in a higher rate.

One can just hope that someday sensibility will prevail.

Middle East - A complication for the existing structural issues of India

The trouble in the Middle East which has most of the OPEC countries in the belt is a potential threat to India, that too in a much more significant way than any of the developed or emerging economies. The international crude oil market has already factored in the distress in the Middle East countries.

The problem for India is not only that they are the 8^th largest net importers of oil (1,200,000 barrels per day), but 21^st when it comes to oil reserves. The steep rise in international crude oil prices not only means havoc for the Indian Oil Marketing companies but the countries fiscal health as well. Currently the OMC’s (Oil marketing companies) in India are losing 1 lakh crore by selling petroleum products at subsidized rates. The government has decontrolled petrol prices which already is fuelling inflation amid rising food inflation and a strong need is felt to decontrol diesel prices otherwise another subsidy burden awaits the government.

All said and done the problems in middle-east might ease out in sometime but it will be pretty optimistic to think so, in such events any country who has a reasonably good oil reserve will not face as many issues as a country like India which runs to the spot market every now and then to buy oil. The U.S has been able to increase its strategic crude oil reserves to a decent 60 days of storage where as India has been forced to buy spot at peak rates due to low strategic storage capacity of its refiners and stockist. Of late, India has started building a grossly inadequate strategic crude storage capacity of two weeks compared to the 60 day storage capacity of U.S and 90 day capacity of Germany and France. Even China which is at times inappropriately considered India’s peer has embarked on a project to store 90 days of oil by 2020 to meet its energy security.

The solution…………don’t we all know that.