May 24, 2007 1
Asia Markets Research
Indian Markets Outlook and Strategy Rajeev Malik (65) 6882-2375
limited credit demand at that time. However, a strong rebound in demand for credit prompted banks to cut their excess bond holdings to fund their asset expansion.
However, this easy way to generate funds hit its limit late last year with bond holdings declining, to be perilously close to the 25% limit, with some banks probably at that limit.
Since that time, banks have resorted to more aggressive hikes in deposit rates to fund loan growth.
The case for SLR reduction
The most pressing reason for a cut in the SLR ratio is the emergence of a likely mismatch this year between the increase in aggregate deposits and the expected borrowing by the government. Essentially, the demand from banks to meet the SLR requirement owing to the expected increase in deposits will probably outstrip the supply of bonds by the government. Indeed, the RBI's own assumption of increase in bank deposits of INR4900 billion (20%oya) in 2007-08 suggests that demand from this component alone can be close to INR1225 billion, and will outstrip the official net issuance target of INR1090 billion. This demand is in addition to increasing demand from the non-bank segment, and the need for many banks to strengthen their SLR portfolio for liquidity management purposes.
Separately, over the medium-term, the elevated growth momentum of the economy will need more funds, and the RBI will likely cut the SLR ratio further, especially as concerns over inflation and the pace of lending subside and facilitate a more benign interest rate outlook. However, it is unlikely to announce a roadmap for either the magnitude or the timing of the potential cuts. Uncertainties over the government's borrowing requirement next year (in the runup to the next general election that is to be held before May 2009) will prompt the RBI to adopt a cautious approach.
Statutory liquidity ratio
% of net demand and time liabilities
Special Focus
Imminent cut in SLR unlikely
20 25 30 35 40
90 92 94 96 98 00 02 04 06
Siddharth Mathur (65) 6882-2214 [email protected] Vikas Agarwal(91-22) 6639-2961 [email protected]
• Reduction in the statutory liquidity ratio (SLR) in the near term unlikely
• Central bank likely to wait for more convincing data signaling moderation in inflation and loan growth
• SLR cut likely to be a 2H-FY07/08 event, with the October midyear review possibly the preferred time
• Reduced bond demand will weaken bonds following an SLR cut; swaps likely to outperform bonds
Markets running ahead of themselves
Indian bond and equity markets are increasingly discounting the possibility of an early cut in the statutory liquidity ratio (SLR) by the central bank. However, JPMorgan maintains the view that an SLR cut is more likely in the second-half of the current fiscal year, with a possibility of an announcement in the October midyear review of the Reserve Bank of India's (RBI) annual policy for 2007-08 (year that began April 1). SLR cuts should be viewed as a structural reform, the timing and scope of which will be partly dictated by the flexibility available to the RBI owing to the cyclical constraints.
The Indian banking sector has to maintain a statutory liquidity ratio (SLR) of 25% of net demand and time liabilities.
This ratio has been cut from 38.5% in mid-1990s, but the current ratio has been unchanged since October 1997.
Undoubtedly, there is scope for further cut in the SLR, as the current floor appears harsh relative to those prevailing in other countries and in light of the globalization pressure on the Indian banking sector. The ratio is also high relative to the resource needs of the rapidly growing economy.
However, several issues need to be balanced before the RBI will move toward cutting the SLR ratio. A high SLR ratio in the past was a convenient way of funding the government's borrowing program. However, the improvement in fiscal dynamics in recent years—and expectations of further improvement over the medium-term that will further lower the borrowing requirement of the government—set the stage for lowering the SLR ratio as a structural reform. Still, the move forward will be gradual, as there is uncertainty over the fiscal outcome for the next couple of years (see more below).
Banks' bond holdings peaked at 42% in 2003, far above the
mandatory SLR requirement of 25%, owing mainly to
May 24, 2007 2
Asia Markets Research
Indian Markets Outlook and Strategy Rajeev Malik (65) 6882-2375
SLR cut unlikely before October
We believe three preconditions have to be met before the RBI presses the SLR button. (1) WPI inflation has to be back in the RBI's comfort zone; (2) loan growth has to decelerate further; and (3) a substantial portion of the government's borrowing program for the current fiscal year should be over.
Already, WPI inflation and loan growth are moderating, and will probably prompt the RBI to be on hold for next several months. Additionally, the government's first-half borrowing, which is around 60% of total full-year gross borrowing, will be over by the time the RBI undertakes a midterm review of its 2007-08 annual policy at its October meeting.
Market implications
Bonds will weaken as demand reduces following a cut in SLR, but interest rate swaps will likely outperform bonds.
Bonds: An SLR cut will be an unambiguous negative development for bonds, as it would sustainably reduce the demand for bonds from banks. Note that banks remain the largest investor segment for government bonds.
Further, a small SLR cut may trigger fears of more follow- up cuts, and could thus hurt market sentiment for a protracted period. That having been said, note that an SLR cut will likely only be announced following a visible slowdown in credit growth, and, accordingly, any spike in yields will likely be restrained by the more bond-friendly environment prevailing at the time.
Swaps: Swap rates, particularly at the long end of the curve, are likely to rise in sympathy with bond yields following an SLR reduction. But again, we expect the swap curve would have previously dis-inverted as the RBI’s hawkish bias softened in the lead-up to an SLR cut. Note that an SLR cut will free up bonds that banks may place as collateral at the RBI’s repo window during periods of tight liquidity, and thus would help contain upside volatility in overnight rates. Accordingly, swap term premiums could soften following an SLR cut, although that effect will likely be overwhelmed by the demand to hedge bond holdings.
Risks to outlook
An unexpected pickup in inflation and/or in the pace of lending could delay the potential SLR cut, but not by much.
Further, the magnitude of capital inflows could clearly
Banks’ government bond holdings percentage of net demand and time lliabilities
continue to complicate monetary management. Conversely, easing capital inflows could first prompt the RBI to cut the cash reserve ratio (CRR), which it has been hiking as a way to sterilize its intervention in the foreign exchange market.
Still, the advantage of cutting the SLR is that unlike a CRR cut, which will infuse liquidity, a cut in SLR will only make liquidity available at the repo rate.
Increased issuance under the market stabilization scheme (MSS), which qualify for SLR status, could also delay a cut in SLR, but this approach is not a lasting solution. Another response that could delay an SLR cut could be to gradually make oil and food bonds issued by the government eligible for SLR. There are currently around INR500 billion of these bonds, and this option could provide an interim buffer.
However, this approach is unlikely to be adopted as it may set an undesirable precedent by sanctioning special-case subsidies.
Siddharth Mathur (65) 6882-2214 [email protected] Vikas Agarwal(91-22) 6639-2961 [email protected]
25 27 29 31 33 35
May-05 Aug-05 Nov-05 Feb-06 May-06 Aug-06 Nov-06 Feb-07
Credit growth easing but still higher than the RBI’s 24-25%oya target percent oya
20%
25%
30%
35%
40%
45%
Mar-03 Mar-04 Mar-05 Mar-06 Mar-07
25% SLR
Note that 25% is the current minimum mandated SLR
May 24, 2007 3
Asia Markets Research
Indian Markets Outlook and Strategy
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Asia Markets Research
Indian Markets Outlook and Strategy
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