RBI cut the SLR (Statutory Liquidity Ratio) of banks by 50bps in its policy review on 5th of August 2014. Apart from this there was no change in policy rates on Repo and CRR (Cash Reserve Ratio) that were maintained at 8% and 4% respectively.
RBI also reduced the HTM (Held to Maturity) portfolio limit on SLR securities that comprises of Government Bonds and State Development Loans (SDL) from 24.5% to 24%. This move is in accordance with the lowering of SLR by 50bps. Read our tutorial on HTM portfolios of banks to know all about HTM.
Initial reaction by the bond market was negative as SLR cut implies lower demand for government bonds by banks. Benchmark ten year bond, the 8.40% 2024 bond saw yields rise 6bps post policy. However markets will get back towards a longer term focus on lower fiscal deficit and falling inflation trends and bond yields will start trending down again.
The SLR cut is by itself positive as it signals that the RBI is confident of the government’s commitment to fiscal consolidation with Budget 2014 drawing a fiscal roadmap of 4.1%, 3.6% and 3% deficit over this fiscal and the next two fiscal years respectively. RBI believes that banks will not be called upon to support government borrowing in the coming years. Banks are anyway running SLR levels around 28% and hence do not really need to stock up on government bonds.
Banks would also not come and sell government bonds as Incremental Credit Deposit Ratio (ICDR) is at around 53% fiscal year to date. Watch our two minute concept video on ICDR
Liquidity that has been seeing ups and downs in the recent days has largely been due to movements in government cash balances with the RBI. The market had to content with sudden tightness in liquidity over the last couple of weeks that has seen deficit rise from levels of Rs 700 billion to Rs 1300 billion. RBI added Rs 900 billion through term repos last week in the face of higher system liquidity deficit and this cooled down money market rates. Liquidity is now back in comfort zone with bids for reverse repo higher than repo in the last two days.
RBI will be paying a dividend of over Rs 400 billion to the government in mid August and this will add more liquidity into the system.
The improving system liquidity coupled with RBI commitment to its CPI (Consumer Price Index) inflation targets of 8% and 6% by January 2015 and January 2016 respectively and government’s commitment on fiscal consolidation is highly positive for bond markets. Bond yields should first start trending down at the short end of the curve on easing liquidity and then the whole curve will fall as rates drop.
The government bond yield curve is flat at present with one to thirty year bond yields trading in a small 30bps range. The curve should start steepening on easing liquidity and then start falling going forward as RBI looks to ease policy as inflation trends down.
Arjun Parthasarathy will take all your questions on the policy at 2 pm on the 5th of August 2014,Tuesday.To interact with Arjun Parthasarathy dial conference call numbers.