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February 2014

Call money rates moved in a narrow range amid volatility, and closed January at 8.80-8.90% compared with December’s 8.75-8.85%. The rates had dipped in the early part of the month because spending by the government ensured a comfortable liquidity position in the banking system. Lending by the Reserve Bank of India (RBI) through its term repo window and purchases of gilts via open market operations also supported liquidity, as did capital infusion into state-owned banks by the government. However, service and excise tax outflows checked the decline in overnight rates. Regular demand for funds (average daily net borrowing under the Liquidity Adjustment Facility (LAF) was Rs 34,531 cr in January, compared with Rs 23,999 cr in December) from banks to meet their reserve requirements, coupled with a 25 basis-point hike in the repo rate by the RBI at its monetary policy review on January 28 put further upward pressure on call rates. 

Government bond prices rose in a volatile first month of the year, with the yield on the 10-year benchmark paper 8.83%, 2023 falling to 8.77% on January 31 from 8.82% on December 31. The early part of January saw yields fall as a decline in retail and wholesale inflation stirred hopes that the RBI may not hike interest rates afresh.  Yields fell on remarks by the RBI Deputy Governor H.R. Khan, which raised hopes that the government might not conduct debt switches announced in the Union Budget for this fiscal till March. What also supported bond prices were value buying amid expectation of a likely increase in foreign banks' participation. This came true later in the month when the RBI doubled the sub-limit for investment in government securities to $10 bn by long-term investors such as sovereign wealth funds and foreign central banks.

 Further rise in bond prices was, however, capped due to the unexpected repo rate hike of 25 bps to 8% by the RBI at its third quarter review of monetary policy held on January 28, 2014. Prices were also affected by weakness in the rupee and on concerns that the government’s budget deficit will exceed its goal as an economic slowdown eroded revenues. The likelihood of the RBI considering retail inflation as a base for its monetary policy actions too negatively impacted gilt prices.


Macro Forecast
Tight liquidity, high government borrowings and limited open market operations create upward pressure on yields. Rising inflation, both at the retail and wholesale level raises the likelihood of another repo rate hike. We expect yield on 10 year G-sec to settle around 8.3–8.5% by March-end 2014.