Credit contraction to aid liquidity, weak rupee to stay below 46

The cut-off yield at Rs 10,000-crore bond auction to set market tone

The rupee is likely to trade in a range of 46.00- 46.15 against the greenback

The benchmark 10-year yield may touch 7.75 per cent

LIQUIDITY

Banks to stay put
The liquidity condition in the banking system is comfortable. But it is the contraction in credit that is saving the banks from liquidity concerns, say analysts.

The two major reasons for liquidity comfort were "� dollar purchases by the Reserve Bank of India (RBI) from the foreign exchange market and the central government stepping up its spending.

Both the factors no longer exist, while the RBI has now turned to selling dollar to prop up the rupee (which results in sucking out of rupee liquidity), the government has exhausted all its cash balances with the apex bank.

Contraction in loan outstandings and an investment squeeze by banks expecting a hardening in interest rates are ensuring a liquidity flush in the banking system.

The banking system in fact is witnessing a shrinking liquidity situation. The outstanding non-food credit has declined by nearly Rs 7,000 crore so far in FY07, despite banks till a few weeks earlier forecasting a continuation in credit demand from the retail segment, particularly home loans, and emergence of investment demand from companies, particularly for infrastructure.

The increase in non-food credit in the corresponding period a year earlier was almost Rs 40,000 crore.

Deposits, the main source of resources for banks is not keeping pace with the growth witnessed a year earlier. The growth in absolute terms has been half of what was seen a year earlier.

Analysts say the banking system may not go back to a situation of liquidity strain, but the surplus funds are expected to dry up, which in turn, would prompt a further hardening of interest rates.

The market is now debating whether the RBI would wait till the July policy review or announce a further tightening much earlier.

CALL MONEY

On a flat run
The overnight interbank call money rate is expected to remain flat with the liquidity still at comfortable levels. Liquidity absorption by the RBI via reverse repo auctions was over Rs 60,000 crore in the last week.

GOVERNMENT SECURITIES

Bearish undertone envisaged
Market players across the board are bearish on the debt market. The contributing factors are expectation of higher inflation due to higher global commodity prices coupled with strong GDP growth which could translate into enhanced pricing power as capacity utilisation reaches limits. Cement is being cited as the most recent example.

Banks are expected to remain focused on short-duration bonds given the interest rate scenario and would have to make room for accommodating demand for credit from the commercial sector.

This is expected to keep up the pressure on yields through subdued demand for primary supply.

The yield on the 10-year benchmark bond is expected to rise to as high as 8 per cent by the end of this year from 7.67 per cent now. The benchmark yield is likely to test 7.75 per cent this week.

The benchmark yield rose 6 basis points last week on concerns that rates would rise because of shrinking rupee liquidity. The cut-off yield at tomorrow's auction of 9.39 per cent, 2011 bond for an amount Rs 10,000 crore is being watched keenly. Bond dealers are expected to bid aggressively for it.

The corporate bond market is expected to remain subdued with banks keeping away from making investments. The primary market is seeing a slew of issues by banks and financial institutions, basically to raise Tier-1 and Tier-II capital.

The demand for these instruments is mainly from the insurance companies, which keep looking for long-term investments.

RUPEE

Weak undertone
The sentiment in the foreign exchange market remains slightly negative for the rupee.

The rupee has lost heavily against the dollar primarily due to outflows as foreign institutional investors (FIIs) sold part of their holdings in Indian equities.

The offshore arbitrage also added to the fall in the rupee. The rupee would remain under pressure and is expected to trade below 46 per dollar this week.

This is due to the fear of continuing weakness in the stock market and in the global metals markets. The rupee's real effective exchange rate (REER) has fallen from a high of 111.6 at the time of the revaluation of the Chinese currency to 102.6 as on May. According to a Merrill Lynch forecast, that rupee would further depreciate to below 100 on the REER index.

The related phenomena of tighter global liquidity, the impact of current account deficit and increasing nervousness in the emerging markets should lead to continued rupee underperformance in a relatively strong Asian region.

India's relatively poor current account situation makes it vulnerable. If oil prices maintain their current level throughout the financial year, the current account deficit may increase to 3 per cent of the GDP in 2006-07, from a projected 2.1 per cent in 2005-06.

Oil represents more than 30 per cent of merchandise imports, significantly more than that in Asia's more open economies.

Despite India's inspiring longer-term prospects, the short-run foreign direct investment (FDI) situation appears unexciting.