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Aftermath of the US Debt Downgrade

The downgrade of US debt is the second shock to hit the Indian financial markets after the 50 bps hike in repo rates by the RBI on 26 July 2011. While concerns have been raised about the resulting impact on financial markets and economic growth, an analysis reveals that except for the foreign exchange and the equity markets, the impact of the downgrade so far has been muted on all fixed income markets including the money market. Further, inward capital flows are likely to regain buoyancy in the coming months and the near and medium-term outlook for growth and financial stability should remain intact. Given the persistent demand pressures from the private, public and export sectors, and the downside risks to sustenance of capital flows, the appropriate policy stance for the central bank would be to persevere with its anti-inflationary stance.

MONEY MARKET REVIEW

Aftermath of the US Debt Downgrade

EPW Research Foundation

dismissed the credit rating agency’s stance. It is notable that the other two major credit rating agencies – Moody’s and Fitch

– continue to rate the US government bonds AAA.

Second, it is rather ironic that the downgrade was announced soon after the US

The downgrade of US debt is the second shock to hit the Indian financial markets after the 50 bps hike in repo rates by the RBI on 26 July 2011. While concerns have been raised about the resulting impact on financial markets and economic growth, an analysis reveals that except for the foreign exchange and the equity markets, the impact of the downgrade so far has been muted on all fixed income markets including the money market. Further, inward capital flows are likely to regain buoyancy in the coming months and the near and medium-term outlook for growth and financial stability should remain intact. Given the persistent demand pressures from the private, public and export sectors, and the downside risks to sustenance of capital flows, the appropriate policy stance for the central bank would be to persevere with its anti-inflationary stance.

Team led by K Kanagasabapathy and supported by Anita B Shetty, Vishakha G Tilak, V P Prasanth, Rema K Nair, Shruti J Pandey and Sharan P Shetty.

Economic & Political Weekly

EPW
august 20, 2011

1 Introduction

F
inancial markets, particularly of advanced countries, were rattled by the historic downgrading of United States (US) debt from AAA to AA+ by the credit rating agency Standard & Poor’s (S&P) on 5 August 2011, following a protracted and troublesome agreement on debt ceiling reached by the US government three days earlier. This news came as a shock for the Indian financial market, which was still recovering from the policy shock of the unexpected hike in the repo rate by 50 basis points (bps). While the downgrade itself has raised serious doubts about the credibility of S&P, market behaviour across the world has turned adverse. This has raised fears about a double-dip recession particularly in the US, and its consequential impact on emerging markets such as India. Those in official policy circles expect the downgrade to have a minimal impact on our financial markets and also on the growth prospects of the economy. There are demands from the industry that the central bank should give a pause to policy tightening to avoid economic slowdown.

Against the above backdrop, this note

addresses three questions. First, how

severe is the US debt downgrade in gener

al and what are the implications for India’s

own debt? Second, what has been the

impact of this downgrade on money,

forex, government securities, and equity

and bond markets on top of the policy

shock of 26 July 2011? And third, what is

the likely impact on India’s growth pros

pects and the implication for policy per

spectives in the current context?

1.1 US Debt Downgrade

Even before the downgrade, the US government had pointed out a serious error in S&P calculation (amounting to around $2 trillion) of US deficits. Soon after the downgrade, the Obama government practically

vol XLVI No 34

president managed to reach a ceiling/budget cutting agreement with some difficult and protracted negotiation with the opposition. Against the lurking fear of a historical debt default by the US government through July, the new agreement reached on 2 August was not a mean achievement, and should have been evaluated positively.

Third, the rationale for downgrading seems to be based more on domestic political dynamics which hampered a smooth and quick agreement on the debt ceiling issue, rather than on fiscal and economic fundamentals relating to medium-term debt sustainability. According to S&P, “difficulties in bridging the gulf between political parties” was the major reason for the downgrade. Perhaps the agency wanted an adjustment of at least $4 trillion by 2012 against the agreed level of $2.4 trillion. This is more of a technicality which would be difficult to justify empirically, especially after the error by the agency.

Fourth, the probability or possibility of a debt default in the US is mainly a technical one, because of its own stringent debt ceiling discipline which practically no other country has. All countries, with the exception of Denmark, have a discipline for spending, but not for borrowing. The euro area’s fiscal discipline seems to be observed more in its breach rather than in observance, as is evident from the recent experience. In India, for instance, though the Constitution permits legal imposition of debt limits by both the central and the state governments, in practice this has not been exercised. There are also provisions to violate fiscal rules under unforeseen circumstances. Against this background, some difficulty in reaching a smooth agreement quickly should not be weighed against the US government. The current situation is definitely not worse than the beginning of the global financial turmoil in mid-2007 or the fall of Lehman Brothers in September 2008, both originating in the US.

MONEY MARKET REVIEW

A related question is: how serious is the downgrading for India’s own position? India is rated seven notches below AA, at BBB-, with a stable outlook by S&P. This reflects the lowest investment grade ratings for India, only one notch above the junk category. Goldman Sachs recently upgraded Indian equities to “market weight” from “underweight”. Even with its high debt and deficit levels, the country is in a relatively comfortable position compared to the US and other advanced countries. Even as the countries in Europe seem to be facing credit rating cuts, India is rightly pressing rating agencies to secure an upgrade. The finance ministry has asked all the financial sector regulators to look at measures to improve credit rating.

1.2 Impact on Financial Markets

An attempt has been made to examine the impact of the two recent shocks, viz, the high government borrowings, since the bank credit actually declined during this period.

  • (3) Corporate Bonds: The spread over 10-year G-sec yield for AAA rated bonds continued to increase after the policy rate hike and also after the US debt downgrade. The increase was seen mainly in the debt of non-banking financial companies (NBFCs), corporates and banks. After witnessing a decline, the debt of public sector banks (PSBs) and financial institutions (FIs) saw an increase after the US debt downgrade.
  • (4) Equity and Foreign Exchange Market: The nexus between the stock market indices, foreign institutional investment (FII) flows and the rupee exchange rate became evident during this period. Significant FII outflows were noticed post-US downgrade, starting 5 August 2011. Meagre inflows were seen during 11-12 August 2011. FIIs remained net sellers on account of negative global
  • Table 1: Impact of Policy Rate Hike and US Debt Down Grade

    cues as well as domestic concerns such as rising inflation and lower-than-expected corporate earnings. FII outflows triggered a fall in share prices and also contributed to depreciation in the rupee exchange rate. The rupee was range-bound between Rs 44.29 per dollar and Rs 44.42 per dollar after the policy rate hike. It depreciated steeply to Rs 45.57 per dollar by 12 August 2011 and showed a depreciating trend after the policy rate hike. The rupee movement continued to be volatile both pre and post US downgrade starting 5 August 2011.

    1.3 Impact on Growth Prospects

    It is clear from the analysis in the previous section that except for the capital market and the foreign exchange market, the impact of the US debt downgrade was muted in all other fixed income markets. Hence, apart from the transmission effect of the

    policy rate hike by the Reserve Bank of Call Money 1 Year G-Sec 5 Year G-Sec 10 Year Rupee Corporate BSE Sensex FII Inflows (Net) G-Sec Exchange Bonds

    India (RBI) on 26 July 2011 and the US debt

    Rates Rates Rates Rates Rates Spreads* Debt Equity Total

    downgrade on 5 August 2011 on financial Pre-Policy Rate Hike markets. The relevant data are presented 15-Jul-2011 7.05 8.04 8.27 8.25 44.53 104 18,562 196 338 534 18-Jul-2011 7.67 8.05 8.27 8.27 44.53 104 18,562 385 145 530

    in Table 1 and in illustrative Graphs A to D

    19-Jul-2011 7.65 8.05 8.26 8.24 44.59 93 18,654 311 -53 258

    (pp 63, 64). The analysis reveals that

    20-Jul-2011 7.59 8.01 8.27 8.27 44.46 96 18,502 159 418 576

    except for the foreign exchange market

    21-Jul-2011 7.59 8.01 8.28 8.27 44.43 106 18,436 -166 -31 -197

    and the equity market, the impact of the

    22-Jul-2011 7.36 8.01 8.31 8.31 44.38 93 18,722 -816 -172 -988

    US debt downgrade was muted on all fixed 25-Jul-2011 7.58 8.01 8.30 8.29 44.42 90 18,722 1,840 525 2,365

    income markets including the money mar-Post Policy Rate Hike 26-Jul-2011 7.64 8.01 8.38 8.38 44.29 99 18,518 560 240 800

    ket, with the exception of the corporate

    27-Jul-2011 8.02 8.01 8.43 8.46 43.95 95 18,432 572 -42 530

    bond market which witnessed some pres

    28-Jul-2011 8.00 8.31 8.43 8.44 44.13 89 18,210 131 109 240

    sure on bond spreads.

    29-Jul-2011 7.56 8.31 8.42 8.46 44.16 91 18,197 -1,678 417 -1,260

    The important conclusions that emerge

    1-Aug-2011 8.00 8.35 8.39 8.43 44.05 94 18,314 42 -619 -577

    are summarised below. 2-Aug-2011 7.98 8.35 8.41 8.44 44.23 97 18,110 -452 157 -295

    (1) Government Securities Market: The 3-Aug-2011 7.96 8.35 8.38 8.41 44.38 97 17,941 76 -83 -6

    yields on one, five and 10-year benchmark 4-Aug-2011 7.81 8.35 8.38 8.42 44.42 91 17,693 -1,169 -801 -1,970 Post US Down Grade

    G-secs had gone up significantly after the

    5-Aug-2011 7.34 8.26 8.31 8.31 44.80 106 17,306 -533 -147 -680

    policy rate hikes. However, after the US

    8-Aug-2011 7.98 8.26 8.26 8.24 44.96 107 16,990 -453 -1,610 -2,063

    debt downgrade, the rates showed a fall

    9-Aug-2011 7.98 8.26 8.22 8.19 45.17 105 16,858 -147 -1,110 -1,257

    ing trend, perhaps on the market expecta-10-Aug-2011 8.00 8.27 8.22 8.22 45.21 99 17,131 -343 -1,961 -2303

    tion that the central bank could possibly give a pause to further rate hikes.

    (2) Call Money Market: The call money rate starting 15 July 2011 continued to show an upward movement and the rate remained high, post policy rate hike. The call rate hovered around 7.98% and remained flat

    11-Aug-2011 7.98 8.27 8.24 8.20 45.27 101 17,059 1,449 249 1,698

    12-Aug-2011 7.40 8.11 8.25 8.26 45.37 16,840 57 94 151

    * Spread over 10 year G-Sec yield for AAA rated bonds. Compiled by EPWRF. Source: RBI, Fimmda, SEBI, BSE.

    Table 2: Money Market Activity (Volume and Rates)

    July 2011 June 2011
    Instruments Daily Average Volume (Rs Crore) Monthly Weighted Average Rate (%) Range of Weighted Average Daily Rate (%) Daily Average Volume (Rs Crore) Monthly Weighted Average Rate (%) Range of Weighted Average Daily Rate (%)
    after the US debt downgrade. The net liquidity adjustment facility (LAF) borrowings by banks moved in tandem with call money rates signifying that tighter the market, the more the borrowings. The tightness in money market was more due to Call Money 11,040 7.60 Notice Money 3,031 7.69 Term Money @ 221 -CBLO 44,173 7.33 Market Repo 12,238 7.52 @: Range of rates during the month. Source: www.rbi.org.in. and www.ccilindia.com 6.47-8.02 5.35-7.95 6.30-10.00 1.45-7.98 1.50-8.01 9,983 2,685 186 39,264 16,183 7.47 7.49 -7.06 7.29 6.21-7.71 5.96-9.15 8.10-10.50 2.15-7.60 5.00-7.57
    62 august 20, 2011 vol XLVI No 34 Economic & Political Weekly
    EPW

    Graph A: Government Securities – Volumes and Rates Volumes

    26500
    25000
    23500
    22000
    20500
    19000
    17500
    16000 5 year G-Sec
    14500
    13000
    11500
    10000 10 year G-Sec
    8500
    7000
    5500
    4000 1 year G-Sec

    After Policy

    Announcements Before Policy Announcements

    10 year G-Sec

    Rates

    8.50

    8.45

    8.40

    5 year G-Sec 8.35

    8.30

    8.25

    8.20

    1 year G-Sec

    8.15

    8.10

    8.05

    8.00

    15/7 17/7 19/7 21/7 23/7 25/7 27/7 29/7 31/7 2/8 4/8

    policy rate hikes, any fear of additional impact of the debt downgrade is not well-founded. Any liquidity concerns in either the money or forex markets as a fallout of the US debt downgrade has been quenched in time by the RBI’s assurance that adequate rupee and forex liquidity will be sustained to prevent any excessive volatility in interest rates or in the rupee exchange rate.

    India, by virtue of its modest openness and its track record of prudential policies, may not face any serious disruption of a lasting nature. There could be some hiccups, like the hardening of government securities and bond yields, combined with some stock market correction, but the near and medium-term outlook for growth as also for financial stability should remain intact.

    Though uncertainty in global markets seems to have somewhat reversed the capital inflows into the economy, this can, at best, be treated as temporary. The accommodative policy of the US and other advanced economies to prevent recessionary trends will contribute to further augmentation of global liquidity seeking better returns. Given the interest rate differential, the current resilience of the Indian economy and medium-term growth prospects, the country

    Economic & Political Weekly EPW august 20, 2011

    will not be exceeded. To rein in deficit, the government has been fol-

    Graph B: Net LAF and Call Money Rates

    lowing a strategy of issuing 86000 a large volume of treasury

    76000

    bills (TBs) including cash management bills (CMBs) 66000 to meet temporary mis

    56000

    matches so that such gaps do not result in larger issu

    46000

    ance of dated government

    36000

    securities. However, in the

    MONEY MARKET REVIEW

    for the central bank would be to persevere with its anti-inflationary stance and continue tightening rates if needed. It is commendable that both the government and the RBI have chosen this path so far.

    2 Money, Forex and Debt Markets

    A disappointing second-quarter gross domestic product (Q2 GDP) growth and the debt ceiling stalemate in the US unsettled financial markets in July. Barack Obama’s statement that the US may experience a deep economic crisis and the heightened fear about the US losing its AAA debt rating flustered the entire market outlook. In addition, the failing efforts by the eurozone leaders to prevent the region’s peripheral sovereign debt crisis spilling over to Italy and Spain also dampened market sentiments. In general, the markets faced a turbulent situation worldwide.

    After the drying up of liquid funds in the first-quarter of 2011-12, the beginning of the new quarter witnessed some moderation. A steep fall in bank credit to the extent of Rs 81,000 crore contributed to easing of liquidity. However, a fall in deposit growth

    810

    710

    610

    510

    410

    310

    210

    110 0

    US Rating

    Downgrade

    6/8 8/8 10/8 12/8

    is bound to remain one of the best destinations for

    foreign investment. Hence, it is expected that the inward capital flow will regain its buoyancy in the coming months.

    Despite hardening of interest rates, evidence from the recent industrial production numbers, growth in leading indicators of activity in various services sectors and a significant pick-up in exports suggest that the current growth momentum is intact. At best, there could be only a slight moderation in growth, but definitely not a slowdown.

    Fiscal position is another soft spot in the economy. The government has, however, been assuring that the fiscal deficit target of 4.6% for the current fiscal year

    26000 Call Money

    absence of windfall revenues such as the spectrum

    16000 7.00

    15/7 17/7 19/7 21/7 23/7 25/7 27/7 29/7 31/7 2/8 4/8 6/8 8/8 10/8 12/8

    auctions and prospects of

    Before Policy After Policy US Rating 8.20 Announcements

    Downgrade

    Announcements

    8.00

    Net LAF

    7.80

    7.60

    7.40

    7.20

    increase in subsidy payments, there is the

    risk that this year’s budget may put addi

    tional demand pressures stoking inflation.

    The domestic currency may harden in case

    of a pronounced slowdown in developed

    economies, but the slowdown in the global

    growth is also expected to bring commodity

    prices to more affordable levels. This trend

    is amply reflected in moderating crude oil

    and metal prices. The other side of this

    story is that growth may not suffer if public

    sector demand increases.

    Given the persistent demand pressures

    from the private, public and export sectors,

    and the downside risks to sustenance of

    capital flows, the appropriate policy stance

    vol XLVI No 34

    at Rs 7,500 crore continued to stress the system on top of the Rs 73,000 crore outflows through investment in government securities. The short-term money market rates continued to hover around the repo rate of the RBI due to sustained demand for funds from banks on the back of huge

    Table 3: RBI’s Market Operations (Rs crore)

    Month/Year

    Jan-2011Feb-2011Mar-2011Apr-2011May-2011Jun-2011Jul-2011

    OMO LAF (Average Daily (Net Purchase(+)/Sale(-)) Injection (+)/Absorption(-))

    17,510 90,349 2 79,677 -14 87,950 16 4,264 1 53,666 981 72,204 -6 37,683

    Source: RBI’s Weekly Statistical Supplement.

    MONEY MARKET REVIEW

    Graph C: Corporate Bond Spreads

    75 85 95 105 115 125 135 Before Policy Announcements After Policy Announcements US Rating Downgrade Corporates PSU and FIs NBFCs Banks

    15/7 17/7 19/7 21/7 23/7 25/7 27/7 29/7 31/7 2/8

    market borrowing by the government. The hike in repo rate by 50 bps, higher than the forecast by economists, surprised market participants. Any hope for a pause in the rate hike faded after the finance minister hinted that the central bank could continue with its hawkish policy stance. The rising domestic interest rates and spreading weakness in dollar propelled the rupee to continue to strengthen in July as in June. The healthier portfolio inflows also boosted the rupee value.

    The rising food inflation and crude oil prices fuelled inflationary pressures and raised concerns about interest rates. Added to that, the expectation that the fiscal deficit may exceed the targeted 4.6% of GDP put pressure on yields. The yields across maturities hardened, with the 10-year security touching 8.5% towards the end of July. However, better credit-deposit ratio at 73.08 in late July improved the appetite for a huge supply of bonds. To add depth to the market, the RBI recently announced the reintroduction of inflation-indexed bonds. The corporate bond market remained afloat with bank lending rates on the rise.

    2.1 Money Market

    In addition to the hike in the repo rate, a strong demand from the banks on the back of huge government borrowings kept the short-term rates across the segments firm throughout the period. However, the overnight rates displayed a downward trend in the beginning of the month and fell below the 7% mark, but again hardened as the heightened anticipation of a minimum 25 bps hike in key policy rate triggered upward pressure. Still, the rates fell below the repo rate of 7.50% in some intermittent

    64 sessions, but the situation got reversed after the government affirmed that inflation, hovering above 9%, would continue to remain high till December. The higher-thanpredicted 50 bps increase in the key policy rate surprised the market participants, resulting in a consistent rise in rates. The call rates crossed the

    4/8 6/8 8/8 10/8

    prevailing repo rate of 8% on 27 July. However, towards the end of the month, the overnight rates fell marginally and closed at 7.56% on 29 July. Overall, the weighted average call rates hardened by 13 bps during the period of one month.

    Compared with the overnight rates, the remaining short-term money market rates hardened substantially during the period under review, predicting further rate hikes in coming days, with the central bank not giving any signal of a

    Lack of investor appetite on the back of rise in rates coupled with falling credit offtake, rising retail deposits and withdrawal by mutual funds resulted in a gradual fall in the outstanding amount of certificates of deposits (CDs) and commercial papers (CPs). As per the latest available data from the RBI, the volume of outstanding CDs issued by scheduled commercial banks decreased by Rs 11,072 crore during the period of one month and the outstanding amount at the end of the fortnight ending 1 July stood at Rs 4,21,072 crore, with discount rates ranging between 8.19% and 10.21% showing a slight fall. Similarly, the outstanding amount of CPs fell by around Rs 16,532 crore in one month and amounted to Rs 1,04,689 crore as on 30 June. However, the discount rates continued their northward trend and ranged between 8.35% and 13.50%. According to the Fixed Income Money Market and Derivatives Association (FIMMDA), the CDs recorded a notable 36% fall, but CPs recorded a 21%

    pause in the tightening phase of the monetary policy. Term money rates crossed the informal corridor of the RBI, while the notice money and collateralised instruments like collateralised borrowing and lending obligations

    (CBLO) and market repo 15/7 17/7 19/7 21/7 23/7 25/7 27/7 29/7 31/7 2/8 4/8 6/8 8/8 10/8 12/8 moved in a wide range,

    Table 4: Foreign Exchange Market: Select Indicators

    though hovering below

    Month Rs/$ Reference Appreciation (+)/ FII Flows BSE Sensex Dollar Index Rate (Last Friday Depreciation (-) (Equity +Debt) (Month-end (Average)#

    the repo rate.

    of the Month) of Rs/$ (in %) in $ Million Closing)

    Following huge volatil

    Jan-2011 45.74 -2.03 1198 18,328 73.19

    ity, the average daily turn

    Feb-2011 45.37 0.82 -721 17,823 72.22

    over in the short-term

    Mar-2011 * 44.65 1.61 1535 19,445 71.02

    money market instru Apr-2011 44.38 0.61 1616 19,136 69.75
    ments of different tenures May-2011 45.21 -1.84 -948 18,503 69.85
    recorded a considerable Jun-2011 * 44.72 1.10 4,883 18,846 69.76
    rise during July. The over Jul-2011 44.16 1.27 2,399 18,197 69.34
    night segment recorded *: Data relates to last day of the month. #:Nominal Major Currencies Dollar Index. Source: www.rbi.org.in, www.bseindia.com, www.sebi.gov.in, www.federalreserve.gov.
    an increase in turnover of
    11%, followed by notice money (13%), term money (19%) and CBLO (13%). Table 5: Average Daily Turnover in the Foreign Exchange Market* ($ billion) Month Merchant Interbank Spot Forward Total Jan-2011 16.2 (6.3) 51.6 (16.1) 32.0 (18.7) 35.8 (9.4) 67.8 (13.6) Feb-2011 15.3 (5.7) 44.4 (12.8) 27.0 (5.7) 32.7 (15.6) 59.7 (10.9)
    Market repo was the only Mar-2011 14.5 (2.8) 39.4 (-1.8) 25.5 (-7.9) 28.3 (6.9) 53.8 (-0.7)
    segment to record a fall Apr-2011 14.1 (10.8) 40.1 (14.7) 27.7 (20.1) 26.5 (7.6) 54.2 (13.6)
    by 24% in its average May-2011 13.5 (-16.7) 48.3 (-6.3) 28.9 (-9.7) 33.0 (-8.0) 61.9 (-8.8)
    daily trading volume, over Jun-2011 12.7 (-5.8) 48.1 (-0.5) 27.4 (-5.2) 33.4 (1.47) 60.8 (-1.7)
    the previous(Table 2, p 62). month *: Includes trading in FCY/ INR and FCY/FCY. Figures in brackets are percentage change over the previous month. Source: RBI’s Weekly Statistical Supplement, various issues.
    august 20, 2011 vol XLVI No 34 Economic Political Weekly
    EPW

    Graph D: Movements in BSE Sensex and Rupee-Dollar Exchange Rate

    43.00 43.50 44.00 44.50 45.00 45.5016000 16500 17000 17500 18000 18500 19000 19500 Before Policy Announcements After Policy Announcements US Rating Downgrade BSE Sensex (Left axis) Rupee-dollar Exchange Rate (Right axis)

    MONEY MARKET REVIEW

    increase in their average daily trading during July over June.

    The cooling liquidity conditions in the system were reflected in the average net injected amount of the RBI’s LAF window during July, which nearly halved to Rs 37,683 crore compared to previous month. In the initial days of the month, the borrowings by banks in the repo window fell considerably; in the first week, it averaged to around Rs 16,000 crore, but gradually increased in the second week to Rs 23,000 crore per day. Following a rise in call rates, banks borrowed Rs 57,000 crore on an average in the third week, while in the last week, the tendered amount of repos remained almost stable at around Rs 52,000 crore. However, the one-day money market rate crossed the repo rate on several occasions, making the borrowers opt for the repo window. In addition to the repo, banks also used marginal standing facility (MSF) of the RBI and borrowed Rs 4,105 crore on 15 July. Since its inception from 3 May 2011, this is the second time the banks have accessed the MSF window. Earlier in June, they borrowed a meagre Rs 100 crore. Only on four occasions in July, banks parked a total of Rs 12,820 crore in reverse repo window. However, the apex bank managed to limit its lending within 1% of net demand and time liabilities (NDTL) during the month after a long gap. After purchasing securities worth Rs 981 crore during June, the RBI’s open market operations (OMO) window again turned practically inactive in July (Table 3, p 63).

    The newly introduced 91-day TBs in interest rate futures (IRFs) recorded a turnover of just Rs 3,629 crore in 20 trading days in July. The open interest at the end of July remained at Rs 2,963 crore – much lower than the initial numbers – signalling the lack of investor interest.

    2.2 Forex Market

    With the Obama administration facing difficulties in reaching a smooth agreement on raising the constitutional debt ceiling, the prospects of a US debt default kept the US currency under intense stress. Heightened concerns that the country may lose its AAA debt rating, coupled with the weaker-than-prophesied Q2 GDP growth numbers added further pressure. Overall, the adverse market conditions halted the recovery of the dollar and the currency by and large experienced a depreciating trend during July. The dimi nishing value of the dollar was reflected in the dollar index falling by 83 bps in one month.

    The ongoing debt concerns took a toll on the euro also, but the currency managed to limit its losses against the dollar on the hopes of a bailout for Greece, which may contain the eurozone debt sovereign crisis. However, the mounting debt concerns in the US and Europe fuelled safe haven demand for the Japanese yen and the Swiss franc. Both the currencies advanced by a whopping 4% each against the dollar. Currencies of other economies assured of their top AAA debt status also appreciated against the greenback. Almost all Asian currencies strengthened significantly against the dollar, supported by inflows of foreign funds to these countries due to wider interest rate differentials.

    Table 6: Details of Central Government Market Borrowing (Amount in Rs crore)

    Date of Auction Nomenclature of Loan Notified Amount Bid-Cover Ratio Devolvement on YTM at Cut-off Cutt-off Price
    Primary Dealers Price (in %) (In Rupees) tion against the dollar and closed at
    08-Jul-11 8.07% 2017 R 3,000 2.60 nil 8.38 98.65 Rs 44.16 on 29 July as against Rs 44.72 on
    8.13% 2022 R 6,000 1.72 nil 8.48 97.4730 June.
    8.28% 2027 R 3,000 2.68 nil 8.62 97.00 The forward premia across the three
    15-Jul-11 7.83% 2018 R 3,000 2.47 nil 8.28 97.69maturities softened during July despite
    7.80% 2021 R 6,000 1.88 nil 8.25 97.00
    8.30% 2040 R 3,000 2.95 nil 8.59 96.91 volatile movements. The one-month premia
    22-Jul-11 8.07% 2017 R 4,000 2.13 nil 8.33 98.87moved in a higher range of 6.62% and
    8.08% 2022 R 5,000 2.01 nil 8.44 97.467.56% during the month. It softened by
    8.28% 2027 R 3,000 2.45 nil 8.62 75.05 19 bps, predicting that the rupee will con
    29-Jul-11 7.83% 2018 R 3,000 1.98 nil 8.50 96.59 tinue appreciating. However, the three
    7.80% 2021 R 6,000 2.39 nil 8.47 95.60 month premia remained almost unchanged
    8.30% 2040 R 3,000 2.22 nil 8.73 95.49 during the same period and moved in the
    Total for July 2011 48,000 2.22 8.46 95.74 range of 6.27% and 7.11% and ended at
    Total for June 2011 R: Reissue. 51,000 2.26 8.43 97.10 6.70% on 29 July. The six-month premia
    Source: RBI press releases. moved very close to the three-month premia,
    Economic Political Weekly august 20, 2011 vol XLVI No 34 65

    Buoyed by the improved performance of Asian currencies, the Indian currency also displayed its strength. The higher-thanexpected rate hike by the central bank and possibility of further hikes influenced the rupee to post a substantial rise. The domestic currency was also assisted by the broad weakness of the dollar overseas and healthier portfolio inflows (Table 4, p 64).

    The rupee began the month with a sharp rise of 26 paise against the dollar, supported by a strong euro and robust dollar inflows, which helped to offset the impact of weak local shares. The sustained sale of dollars by exporters also strengthened the domestic currency. However, dismal domestic stock market activities restricted the rupee in some intermittent days in the first week, while hectic capital inflows at the end of the week prompted the rupee to advance further. The weakness of the euro against the dollar, the falling local shares in the aftermath of sluggish index of industrial production (IIP) numbers, and the increased demand for the greenback by oil importers forced the rupee to lose around 36 paise on 11 and 12 July. However, revival in share prices and widespread dollar weakness overseas limited its losses, and thus the rupee rose to Rs 44.53 per dollar on 15 July. The rise in inflation at 9.44% for June, yielding negative outlook for growth, disrupted portfolio investors’ sentiments in the later period. Despite a dull share market and crude oil prices ruling above $115 per barrel, the rupee sustained its appreciation since the dollar was under tremendous pressure due to looming rating concerns in late July. Overall, the rupee posted a striking 1.27% apprecia

    EPW

    MONEY MARKET REVIEW

    but stayed between 6.01% and 6.84%, and softened by 14 bps over the previous month, to close at 6.43% on 29 July.

    The trading activity in the foreign exchange market fell by 1.7% in June over May despite 13% growth in exports. The major fall was reported in merchant transactions (-5.8%) followed by spot (-5.2%) and inter-bank (-0.5%). Due to increased hedging activity, the forward market managed to post 1.5% rise in their daily turnover during the period of one month (Table 5, p 64).

    The escalating uncertainty in the external sector prompted the currency derivatives market to report a tremendous growth of 20% in its total turnover during July. Domestic exchanges together recorded 25% jump in their average daily trading also. Individually, futures trading improved by 22%, while the options trading rose by a whopping 52% on an average. Among the currencies traded on the exchanges, EUR-INR recorded a huge 46% increase in daily trading due to ongoing turbulence in the euro area. However, USD-INR contracts continued to enjoy the dominant position in futures trading. Among the exchanges trading in currency derivatives, the National Stock Exchange (NSE) dominated with 45% market share, while the remaining volume was distributed between the Multi-Commodity Exchange (MCX-SX) (33%) and the United Stock Exchange (USE) (22%).

    2.3 Central G-Secs

    Primary issuances continued to be high, amounting to dated central government securities worth Rs 48,000 crore, TBs worth Rs 40,000 crore and CMBs worth Rs 20,000 crore. States’ participation increased to Rs 10,500 crore in July from Rs 9,000 crore in June. Both primary and secondary market yields firmed up.

    During the month, four issuances of central government securities for Rs 12,000 crore each were held between 8 July and 29 July, reissuing seven securities. Out of these seven securities, five were issued twice during the month. Considerable firming up of yield was seen in three out of five reissued securities, namely, 7.80% 2021, 7.83% 2018, 8.30% 2040, over the auctions. The monetary policy action of increasing the repo rate by 50 bps on 26 July had an impact on the auction yields on 29 July. All the three securities issued showed a jump in yield in the range of 14 bps to 22 bps over the auction of 15 July 2011. Two securities maturing in 2022 with the coupon of 8.08% and 8.13% respectively were issued once during the 2.26 times in the previous month. The last auction for the month, conducted on 29 July, completed 73% of the scheduled borrowing programme for the first half of the financial year 2011-12 (Table 6, p 65).

    Improved liquidity in the first half of the month resulted in a higher turnover than that of the second half. During these five weeks, the turnover of the first week was at Rs 32,082 crore which increased to Rs 44,068 crore in the second week and further to Rs 63,611 crore in the third week. In the fourth week, turnover was lower at Rs 50,903 crore which further slipped to Rs 46,102 crore in the last week of the month. So, the overall turnover for the month plummeted by 5% to Rs 2,36,766 crore with increased overall yield to 8.36%. The top traded securities, namely, 7.80% 2021, 8.13% 2022, 8.08% 2022, 7.83% 2018 and 7.59% 2016 contributed almost 94% to the total turnover for the month (Table 7).

    Hardening of yield at the shorter end resulted in narrowed yield spreads for securities maturing in one and five years to 24 bps while yield spread remained at

    month. Overall, the weight-Table 8: Yield Spreads (Weighted Average) – Central Government Securities

    – July 2011

    ed cut-off yield inched up to

    Yield July 2011 Previous Three Six Months 8.46% from 8.43% of the Spread in bps Last Week First Week Entire Month Month Months Ago Ago

    1 Year - 5 Year 5 36 24 31 44 52

    last month. All auctions

    5 Year - 10 Year 2 -4 0 -8 -14 13

    were fully subscribed but

    10 Year - 15 Year ---7 --

    with a lower bid-cover ratio

    1 Year - 10 Year 7 32 24 23 30 65 of 2.22 times compared to Source: As in Table 7.

    Table 7: Predominantly Traded Government Securities (Amount in Rs crore)

    Descriptions July 2011 Previous Month Three Months Ago Six Months Ago
    Last Week (29) First Week (1) Total for the Month (June 2011) (April 2011) (January 2011)
    AMT YTM AMT YTM AMT YTM AMT YTM AMT YTM AMT YTM
    GOI Dated Securities
    9.39 , 2011 230 9.37 230 9.37 265 7.95 1,180 7.58 392 7.34
    7.40 , 2012 45 8.26 245 8.00 676 8.05 1,040 8.10 2,665 7.77 1,506 7.49
    7.27 , 2013 45 8.13 15 8.21 210 8.16 295 8.19 370 7.79 1,273 7.63
    7.17 , 2015 325 8.42 105 8.30 786 8.34 1,649 8.37 2,278 8.02 12,799 8.03
    7.02 , 2016 30 8.44 70 8.39 10 8.37 33 7.94 205 8.04
    7.59 , 2016 297 8.38 562 8.35 2,700 8.31 4,096 8.43 2,812 8.17
    7.49 , 2017 5 8.43 275 8.32 262 8.43 190 8.02 805 8.09
    7.99 , 2017 10 8.49 385 8.32 646 8.32 141 8.29 1,479 8.03 8,831 8.10
    7.83 , 2018 2,250 8.43 1,589 8.36 11,976 8.35 8,901 8.42 3,930 8.00
    7.80 , 2021 31,363 8.41 20,186 8.32 1,54,349 8.32 49,676 8.28 24,634 8.03
    8.08 , 2022 5,594 8.46 3,935 8.39 20,292 8.42 24,889 8.45 28,681 8.18 31,845 8.18
    8.13 , 2022 4,215 8.51 2,367 8.40 33,428 8.41 30,168 8.42 22,978 8.13 29,924 8.16
    8.20 , 2022 45 8.40 80 8.47 37 8.11 48 8.20
    8.26 , 2027 310 8.65 618 8.62 2,375 8.61 2,740 8.61 1,914 8.41 6,370 8.48
    8.28 , 2032 721 8.63 1,382 8.64 248 8.64 4 8.36 42 8.50
    8.30 , 2040 158 8.71 85 8.65 1,947 8.61 833 8.60 1,297 8.46 2,206 8.52
    Total (All Securities) 46,102 8.43 32,082 8.36 2,36,766 8.36 1,27,796 8.36 1,00,608 8.09 1,24,462 8.15
    (-) means no trading YTM = Yield to maturity in percentage per annum
    1) Yields are weighted yields, weighted by the amounts of each transaction.
    Source: Compiled by EPWRF; base data from RBI, CCIL.
    66 august 20, 2011 vol XLVI No 34 Economic Political Weekly
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    MONEY MARKET REVIEW

    24 bps for securities maturing in one and 10 years.

    Two auctions of state development loans (SDLs) for Rs 5,250 crore each were held on 5 July and 19 July. In the first issue, Andhra Pradesh, Tamil Nadu, Uttar Pradesh, Uttarakhand and West Bengal raised funds worth Rs 1,800 crore, Rs 750 crore, Rs 1,500 crore, Rs 200 crore and Rs 1,000 crore, respectively. In the second auction, Gujarat, Maharashtra, Punjab, Tamil Nadu and West Bengal mopped up loans worth Rs 1,000 crore, Rs 2,000 crore, Rs 500 crore, Rs 750 crore and Rs 1,000 crore, respectively. Overall, the responses to state loans also were poorer with a lower bid-cover ratio at

    2.28 times, compared with 2.54 times in the last month. Cut-off yield hardened to 8.63% during the month as compared to 8.58% in the previous month (Table 9). In the secondary market, the turnover of SDLs increased to Rs 3,628 crore, with yield at 8.60%, against Rs 2,586 crore with yield at 8.58% in the previous month.

    2.4 Treasury Bills

    TBs worth Rs 40,000 crore were issued during the month against Rs 53,000 crore in June. CMBs worth Rs 20,000 crore were also issued thrice during the month. This reflected the short-term interest of the market as also the government’s intention to keep fiscal deficit at bay, by restricting issues of dated securities.

    Table 9: Details of State Government Borrowings (Amount in Rs crore)

    Date of Auction Number of Total Amount Bid Cover YTM at Cut-Off Weighted Participating States Accepted Ratio Price (%) Average Yield (%)

    05-Jul-11 5 5,250 2.04 8.66 8.64

    19-Jul-11 5 5,250 2.52 8.6 8.58

    Total for July 10 10,500 2.28 8.63 8.61

    Total for June 10 9,000 2.54 8.58 8.58

    Source: RBI press releases. Table 10: Auctions of Treasury Bills (Amount in Rs crore)

    Date of Auction Bids Bid Cover Cut-off Weighted Cut-off Weighted Accepted Ratio Yield (%) Average Yield (%) Price (Rs) Average Price (Rs)

    A: 91-Day Treasury Bills 06-Jul-11 7,000 3.95 8.19 8.19 98.00 98.00

    13-Jul-11 7,000 4.20 8.14 8.10 98.01 98.02

    19-Jul-11 7,000 3.48 8.10 8.10 98.02 98.02

    27-Jul-11 7,000 2.42 8.39 8.39 97.95 97.95

    Total for July 2011 28,000 3.51 8.21 8.20 98.00 98.00

    Total for June 2011 38,000 2.78 8.21 8.19 97.99 98.00

    B: 182-Day Treasury Bills 06-Jul-11 3,000 2.39 8.27 8.25 96.04 96.05

    Accordingly, four auctions of 91-day TBs for Rs 7,000 crore each received better response, with above 3 times of the bid cover and softened yields over auctions till the third auction on 19 July. The picture had changed for the last auction held on 27 July when relatively lower bid-cover ratio of 2.42 times and steep increase in yield rates were seen, following the policy rate hike. Overall, yield remained almost flat with improvement in bid cover ratio to 3.51 times over the period. TBs of 182 and 364-day maturity worth Rs 6,000 each were auctioned twice with higher yield rates. While bidcover ratio improved in the case of 364day TBs, it fell for 182-day TBs. Treasury bill rates approached 10-year yields of dated securities (Table 10).

    In the secondary market, the turnover increased to Rs 33,678 crore from Rs 18,789 crore in the previous month. While the yield rate for 91-day TBs softened a bit, it increased for 182 and 364-day TBs. CMBs were traded for more than Rs 8,000 crore in July across varied maturities.

    2.5 Corporate Bonds Market

    With rising lending rates, the corporate bonds market remained active in the past few months. Both the number of issues and the volume of funds mobilised increased in comparison with the previous month. In all, there were 34 issues in the month of July in comparison to 21

    19-Jul-11 3,000 4.08 8.18 8.16 96.08 96.09

    Total for July 2011 6,000 3.24 8.23 8.2 96.06 96.07

    Total for June 2011 6,000 3.65 8.19 8.18 96.08 96.08

    C: 364-Day Treasury Bills 13-Jul-11 3,000 4.38 8.24 8.24 92.41 92.41

    27-Jul-11 3,000 3.04 8.49 8.47 92.19 92.21

    Total for July 2011 6,000 3.71 8.37 8.35364 92.3 92.31

    Total for June 2011 9,000 2.74 8.32 8.29 92.34 92.36

    issues in the previous month in the private placement segment of the NSE. But the volume of funds mobilised declined by more than 44% in July, in comparison to the previous month. The coupon rates in the upper range remained flat at 11.40% in July as in the previous month. Constant

    D: Cash Management Bills (CMBs)* increase in lending rates by banks made 04-Jul-11 8,000 3.4 8.16 8.16 99.07 99.07

    bank borrowing costlier and therefore,

    18-Jul-11 8,000 3.68 8.05 8.05 98.78 98.78

    though volumes had shrunk, more issues

    21-Jul-11 4,000 4.35 8.05 8.05 98.78 98.78

    approached the market to garner funds

    * First issue of CMBs was for 42 days while last two issues were having maturity of 56 days each. Source: RBI’s press releases. (Table 11).

    According to data published by the

    Table 11: Details of Private Placement in Corporate Bonds in NSE during July 2011

    Institutional Category No of Issues Volume in Range of Range of Maturity in Securities and Exchange Board of India Rs Crore Coupon Rates (in %) Years (y) and Months (m)

    (SEBI), the total secondary market in cor

    FIs/Banks 2 500 9.45 3

    porate bonds turnover reported by the

    NBFCs 15 5470 0.0-9.85 1 to 11

    Bombay Stock Exchange (BSE), the NSE

    Central Undertakings 1 1500 9.63 11

    and FIMMDA together decelerated by

    Corporates 16 564.1 9.70-10.40 2 to 5

    about 1.24% in the month of July in com-

    Total for July 2011 34 8034 0.00-11.40 1 to 11

    parison to the previous month. The turn-

    Total for June 2011 21 14478 9.45-11.40 1 to perpetual Source: www.nseindia.com over fell by as much as 12% in the BSE.

    Economic Political Weekly

    EPW
    august 20, 2011 vol XLVI No 34

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