With govt and SBI doing its job, RBI can go easy on rate hikes

The Reserve Bank of India (RBI) does not have to tighten policy rates further in its quest to bring down inflationary expectations. The government and the State Bank of India (SBI) are helping bring them down on behalf of the central bank.

Policy transmission has never been as effective as it has been in the last couple of weeks. Government bond yields have gone up 45 basis points (bps, where 100 bps make 1 percent) over the last 10 days on the back of the government announcing a higher than budgeted borrowing and on the back of the SBI’s credit rating being downgraded by Moody’s . Government bond yields are trading at the highest levels in over three years and the rise in government bond yields will choke off credit in the economy.

The extra Rs 53,000 crore of borrowing, over and above the budgeted borrowing, for the second half of fiscal 2011-12 has led to a deep worry in bond markets as to how many additional bonds will be absorbed. The first auction of Rs 15,000 crore on 17 October saw high yield cut-offs on the bonds auctioned.

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[caption id=“attachment_106624” align=“alignleft” width=“380” caption=“Going slow on lending to lower-rated borrowers will push up borrowing costs in the system as other state-run banks will follow SBI in shunning lower-rated credits. Reuters”]  [/caption]

The auctioned bonds, 8.07 percent 2017 bond, 8.08 percent 2022 bond, the 8.28 percent 2027 bond and the 8.30 percent 2040 bond, saw cut-offs at 8.64 percent, 8.70 percent, 8.87 percent and 8.92 percent, respectively. Yields on the auctioned bonds have gone up by 40-50 bps across the curve over the last 10 days. The market is expecting more pain in yields in the forthcoming bond auctions.

SBI, post the ratings downgrade by Moody’s, has pledged to keep its NPAs (non-performing assets) under control and has also indicated that it will sell some of its government bond holdings to improve its liquidity position. The bank has said that it will look to lend to highly rated borrowers, given pressures on its asset quality.

Going slow on lending to lower-rated borrowers will push up borrowing costs in the system as other state-run banks will follow SBI in shunning lower-rated credits. If the SBI also sells some of its government bond holdings in the face of a larger than budgeted government borrowing programme, it will push up yields on government bonds.

The system cannot absorb SBI selling of government bonds and fresh supplies from the government. The sharp rise in yields in government bond auctions is a testimony to the market’s nervousness in absorbing bond supply.

The rise in government bond yields will push up borrowing costs across the system while SBI’s reluctance to lend to lower-rated borrowers will push up borrowing costs for the needy. Triple A-rated corporate bonds trade at yields of 9.75 percent across maturities while lower-rated corporate bonds trade at yields of 11.5-12.5 percent across maturities.

Rising government bond yields will push up yields on AAA-rated bonds by at least 25 bps while lower-rated bond yields will rise by 50-100 bps depending on the name.

The rise in yields in the system will bring down credit growth, as investment and consumption will suffer due to higher borrowing costs. SBI has said its credit growth has been a paltry 5 percent for this fiscal year to date and a further rise in borrowing costs will bring down credit growth.

RBI data show that credit growth has been around 19.5 percent year on year as of September 2011 and this could come off from current levels if banks go slow on lending due to worries about rating downgrades.

The RBI has targeted a credit growth of 18 percent for the year 2011-12 to bring down inflationary expectations, which is trending at over 9.5 percent levels. The central bank is looking to bring down aggregate demand in the economy by raising policy rates and tightening liquidity.

Given that the government and the SBI are - possibly inadvertently - acting in concert to push up borrowing costs, the RBI does not have to raise policy rates further to bring down aggregate demand.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.