Impact of the first open market operation by RBI in 2015

Tue, 14 Jul Pre-Open

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The Reserve Bank of India will sell government bonds through open market operations on Monday. It is set to raise Rs 100bn in an aim to drain excess liquidity from the banking system. 

Usually the yield rates on bond have a correlation with the policy rates as decided by the RBI. If the bank rate goes down, usually there is a similar effect in the bond yield rates. In India, the spread between the policy rate and the yield on 10-year paper is very low, but that could probably be undergoing a correction now.

On 15 January, the date of the first rate cut in this phase, the yield on the 10-year government bond dropped from 7.77% to 7.69%; on 4 March, the day of the second rate cut, it fell from 7.7% to 7.69%; and, on the day of the third rate cut on 2 June, it rose from 7.82% to 7.93%. The yield is around 7.8% now. The yield has remained high in-spite of the policy rate cuts which have taken place.

The main reason behind the same is because of the demand-supply balance turning adverse as FIIs are near their buying capacity limit. Overall foreign institutional investors' (FIIs) exposure to Indian debt market is $81 billion and close to 86% of this has been used. FIIs' exposure to government bonds is not even 5% compared with at least 40% in countries such as Indonesia and Malaysia.

RBI will have to take adequate steps to ensure that the FII limit is increased. Another reason being RBI has reduced policy rate by 75 basis points in three phases, from 8% to 7.25%. However State Bank of India (SBI), ICICI Bank, Axis Bank have cut loan rates by 30 basis point each during the same duration. The quantum of cut is less than half of the cuts in the policy rate. The reason for the slow transmission of policy rate cuts to the ultimate customer is as follows - the depositors continue to earn higher rates till their deposits mature but when loan rates are pared, old loans are re-priced according to the new rates. Banks are faster in cutting their deposit rates than their loan rates, as they are always keen to protect their net interest rate margin. The recent crisis in China and Greece has sprouted fears among the foreign investors to invest their money in safe haven such as U.S treasury bonds rather than in emerging markets.

All factors combined may lead to increase in the yield of government securities due to an adverse demand-supply balance.