The downward drift of the rupee has had its repercussions on the bond market, as fears of central bank intervention in the foreign exchange market have led to a fall in the prices of securities. There has been some expectation that the Reserve Bank will tighten liquidity in the money markets to prevent banks from using cheap domestic funds to buy dollars. However, the recent intervention by the central bank has taken the form of administrative measures, which gives ground for comfort that there won't be monetary tightening.
The market, as usual, anticipates matters, and was concerned that a further fall in the rupee would lead to greater intervention. Selling dollars leads to sucking out liquidity from the rupee market, which pushes up interest rates. Hence the poor sentiment in the securities market. But the RBI has also been concerned about the effect its intervention has had on the money markets, and it has been conducting buy/sell swaps to put some of the liquidity back in. That's the reason the forward rates have stayed soft in spite of the decline in the spot value of the rupee.
Despite the measures to stem the fall in the rupee, the decline in securities prices, and the corresponding rise in yields, may not be a temporary phenomenon. To be sure, many analysts had cried wolf throughout last year, expecting the economic recovery to drive up the demand for credit, thereby eroding liquidity with banks and driving interest rates higher. That didn't happen last fiscal, inspite of a smart pickup in bank credit as well as a high level of borrowing by the government. But it's well to remember that the RBI has had to reduce the cash reserve ratio by three percentage points last fiscal to augment banks' liquidity.
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The situation seems to have changed. One factor is the recent fall in foreign exchange reserves. Foreign institutional investors have been net sellers in May. Coupled with the RBI's intervention in the foreign exchange market, the drain in the foreign exchange reserves, if it continues, will cause liquidity to tighten. Also important is the credit to deposit equation in banks. During the second half of 1999-2000, while credit growth has accelerated sharply, deposit growth has declined. Take that trend in conjunction with the government's gargantuan appetite for funds, and interest rates seem to be in a one-way street. Gilt prices fell sharply on Friday on news of another securities auction. The recent jump in the rate of inflation has also been invoked in support of higher interest rates, although much of this increase is owing to higher fuel prices and a hike in administered prices. But the World Bank's report on global commodity markets predicts a decline in stocks leading to higher commodity prices later this year.
All these factors are behind the recent fall in long-dated gilts. Yields on ten-year paper have hardened. The market has lost its appetite for long-dated paper. Of course, a good monsoon will increase the central bank's options to pump in more liquidity. Lowering CRR further could also be considered. But current indications are that interest rates have bottomed out. That is also in line with trends worldwide.