Bond traders will be wondering what the RBI was thinking when the central bank cut the SLR (Statutory Liquidity Ratio) by 1% in its policy review on the 31st of July 2012. The move was most unexpected and quite unwarranted given that the bond market is grappling with continuous supply of bonds from the government. The government is borrowing a record net Rs 479,000 crores in fiscal 2012-13 while targeting a fiscal deficit of 5.1% of GDP.
RBI while cutting the SLR to 23% of NDTL (Net Demand and Time Liabilities) has kept its policy rates of repo and CRR (Cash Reserve Ratio) unchanged. At the same time it has lowered GDP growth forecasts from 7.3% to 6.5% and raised inflation forecast from 6.5% to 7% for the year 2012-13. Government borrowing remaining the same, a lower GDP growth will result in higher fiscal deficit.
The reasoning behind RBI’s move on reducing SLR is that it will help banks lend to productive sectors in the economy. Banks have to purchase less government bonds due to lower SLR (1% SLR cut frees banks around Rs 55,000 crores of liquidity). Banks are however running SLR levels of 27% and higher, which is 3% above the statutory requirement of 24%. The SLR reduction will not force banks to sell government bonds and it will not make banks buy less government bonds to lend to the economy.
Public Sector Banks (PSU Banks) are facing rising bad loans as seen in the first quarter 2012-13 results with banks from PNB to Union Bank seeing NPA’s rise on a year on year as well as on a quarter on quarter basis. Banks prefer to hold government bonds when liquidity is in deficit as they can use the bonds to access the RBI repo window for funds. System liquidity as measured by bids for repo in the LAF (Liquidity Adjustment Facility) of the RBI has been in deficit for two years running and banks have been borrowing from the RBI on a daily basis to meet their liquidity requirements.
The SLR cut took up government bond yields by around 8bps as markets worried on the absorption of bond auctions. The 8.15% 2022 bond yield rose to levels of 8.24% post the SLR cut. Bond markets will take up yields further in auctions as sentiment weakens.
Bond yield rise will not continue for long as markets will start playing for rate cuts in the September/October policy review. The fact that the RBI has lowered growth forecast by a wide margin suggest that the central bank will have to lower rates down the line in the face of economic growth threatening to fall to levels of below 6.5%.
The fact remains that the bond market and the economy will have to wait longer for any kind of positive action from the RBI. In the meanwhile bond yields are likely to go higher and the economy is likely to flounder leading one to wonder why an SLR cut at all. Bond markets were braced for a status quo on policy rates with bond yields trending higher by 10bps in the days leading into the policy. The SLR cut has taken the market by surprise and it remains to be seen how long it will take the market to recover from the shock.