Unexpected SLR cut prolongs the pain

Bond traders will be wondering what the Reserve Bank of India (RBI) was thinking when it cut the statutory liquidity ratio (SLR) by 1% in its policy review on Tuesday to 23% of the net demand and time liabilities.

The move was most unexpected and quite unwarranted, given that the bond market is grappling with a continuous supply of bonds from the government.

The government is borrowing a record net Rs479,000 crore in fiscal 2012-13 while targeting a fiscal deficit of 5.1% of the gross domestic product, or GDP.

The central bank, while keeping its policy rates (repo and reverse repo) and cash reserve ratio unchanged, has lowered the GDP growth forecast from 7.3% to 6.5% and raised the inflation forecast from 6.5% to 7% for 2012-13.

Government borrowing remaining the same, a lower GDP growth will result in higher fiscal deficit.

The reasoning behind the RBI’s move to reduce the SLR is that it will help banks lend to productive sectors in the economy as they would need to purchase less government bonds due to lower SLR.

To be sure, a 1% reduction in the SLR frees around Rs55,000 crore of liquidity for banks.

However, banks are running SLR levels of 27% and higher, which is 3% above the statutory requirement of 24%.

Thus, 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 are facing rising bad loans, as the first quarter results show — PNB, Union Bank have all seen NPAs rise both year on year and quarter on quarter.

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 RBI’s liquidity adjustment facility, has been in deficit for two years in a row 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 8 bps as markets worried on the absorption of bond auctions. The 8.15% 2022 bond yield touched 8.24% post the SLR cut.

Bond markets will take yields up further in auctions as the sentiment weakens.

But bond yield rise will not continue for long as the markets will start playing for rate cuts again in the September/October policy review.

The fact that the RBI has lowered growth forecast by a wide margin suggests that it will have to lower rates down the line as economic growth threatens to fall to 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.

Meantime, bond yields are likely to go higher and the economy is likely to flounder, leading one to wonder why the SLR was cut. Bond markets were braced for a status quo on policy rates with yields trending 10 bps higher 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. 

— Arjun Parthasarathy is editor, www.investorsareidiots.com, a website for investors.