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August 2012

Indian call money rates hovered in the range of 7.9-8.25% for July, amid moderate demand and comfortable liquidity in the system. A slight aberration in the rate was noted on July 4, when rates fell to 7.05-7.25% as the liquidity situation eased sharply with the relaxation in export credit refinance facility initiated by the RBI coming into effect on June 30; the RBI had declared it during its policy review in mid-June.

Gilt prices fell, especially at the end of the month, following the central bank’s surprise cut in banks' statutory liquidity ratio (SLR) during its first quarter monetary policy review; RBI lowered the SLR by 100 bps to 23% with effect from August 11. Prices were affected as a cut in SLR would now mean banks will have to invest minimum 23% of their net demand and time liabilities (NDTL) in gilts as against 24% earlier, and because of which demand for gilts may suffer. The yield on the new 10 year benchmark 8.15%, 2022 bond ended at 8.25% yield on July 31 compared with 8.10% yield on the date when it officially became the benchmark (July 13); the previous benchmark 8.79% 2021 had closed at 8.38% on June 29. Meanwhile, gilt prices also fell intermittently during the month on improved risk appetite globally due to some positive steps to resolve the debt crisis in the Euro zone. Disappointing auction of debt investments for FIIs in the first week of the month, and continuing gilt auctions every week as per the government auction calendar also damped sentiments for gilts in the month.

A further fall in gilt prices was however capped by gains made by gilts during the month. These positive cues came in the form of optimism among investors that the RBI would cut interest rates in the wake of weak domestic industrial production data for May and a fall in the headline WPI inflation to a five-month low of 7.25% in June. Heavy purchases by state-owned banks and strong demand at the weekly gilt auctions also led to rise in bond prices. Bond prices also gained on reports that the government may consider relaxing norms on withholding tax, a move which may spur strong demand from FIIs. Sentiments were also supported by comments from the RBI Deputy Governor that liquidity conditions will determine whether the central bank will carry out bond buybacks. Intermittent weak global risk appetite in the global financial markets due to pessimistic cues from Euro zone and the US also supported the rise in bond prices. Absence of stimulus announcement by US Federal Reserve Chairman further added to the buying spree in domestic bonds.

Macro Forecast
We expect the yield on benchmark 10 year G-sec to settle around 8.0-8.2% by March-end 2013, higher than their earlier expectation of 7.5-7.8% due to a higher fiscal deficit. Though we expect upto a 50 basis points (bps) cut in the repo rate (which forms the floor of the 10-year G-sec yield) by Reserve Bank of India (RBI) in the rest of the fiscal to support growth, downside to 10-year G-sec yield is limited, given the size of the government borrowings.