Gilt rally lures state-run banks

The two-week-old rally in government bonds has started to lure state-owned banks, giving credence to view that market will remain buoyant.

Hitherto on the fringes, state-owned banks have started to build their trading books on renewed hopes that 10-year yield will settle around 7.90 per cent by September-end, down from 7.91 per cent Thursday, treasurers said. Some bank treasurers even expected the 10-year at 7.75 per cent by end of next month.

"The sentiment has turned optimistic because of the drastic reduction in global oil prices and sustained fall in US treasuries," said Rupa Rege Nitsure, chief economist, Bank of Baroda.

In the last two weeks, the 10-year yield has fallen about 35 basis points. State-owned banks' investments are key for this nascent rally to sustain, dealers said.

For several months now, state-owned banks have been on the fringes citing uncertain outlook for interest rates and heavy demand for credit.

In fact, many of them pruned their gilt holdings in the last two years to meet the credit demand. The limited investments they made in gilts were mainly to maintain statutory liquidity ratio.

Even state-owned banks that boast of large balance sheets have been walking a tightrope on their SLR as they have been side-stepping big investments in gilts while giving an impetus to deposit mobilisation.

For the last two financial years, credit off-take from banks rose 30%. It is expected to taper off this financial year and, as a result, spur demand for government bonds.

"We expect credit growth to moderate a bit to around 25 per cent from about 30 per cent last year (2005-06)," said State Bank of India chairman O P Bhatt.

As per the Reserve Bank of India data, bank deposits thus far from April have risen by Rs 1.14 trillion against Rs 53,952 crore rise last year. Bank credit rose Rs 54,300 crore this year against Rs 41,400 crore previously.

The expansion in deposit base would, in turn, require a high investments in gilts to meet SLR. Gilts have rallied since August 8, after the US Federal Reserve, for the first time in two years, did not hike interest rates at a monetary policy meeting. Subsequently, string of weak economic data raised hopes that Fed will hold rates again at its September 20 meeting.

These factors helped the US yields weaken significantly. The 10-year US yield has fallen by about 20 basis points in the last three weeks. Pressure on the Reserve Bank of India is expected to ease if the Fed stops raising rates. Both the central banks have been raising rates for last two years.

Demand for gilts has risen also because Rs 8,500 croreworth of bonds are due to mature Monday. State-owned banks, in particular, are expected to chase short-term bonds to deploy the funds received in lieu of the maturing bonds.

Moreover, traders are upbeat on liquidity after a government official said earlier this week that government was running a surplus balance with RBI.

As on Monday, the government had a surplus balance of Rs 15,000 crore. The comfortable cash position is seen helping the government to keep its market borrowing within the targeted Rs 1.78 trillion for 2006-07 (April-March).

State-owned banks are likely to invest mostly in short-to-medium tenure bonds because concerns over interest rates haven't faded yet. "Winter is approaching and there is tension in Middle East. There is still some uncertainty on oil prices," said Indian Overseas Bank treasurer Sivram Swamy.

RBI has raised interest rates by 150 basis points in the last two years to contain inflationary pressures. The central bank aims to keep inflation below 5.0-5.5 per cent and that target has been under pressure owing to firm oil prices.

Amid rising interest rates, all state-owned banks invested in the recent months was mostly in the held-to-maturity category.

This practice was to avoid period marking of the portfolio to the market and avoid provisions that are required for depreciation of a gilt portfolio. But that is changing slowly as banks have started to hold papers in available-for-sale category to be able to actively trade in bonds and generate profits, dealers said.

"If yields rise, nationalised banks will have to make provisions for depreciation on trading book, while if they buy now in HTM then their investment is protected from any depreciation," said a state-owned bank treasurer. "Concern will be in September end when the evaluation of banks' portfolios will happen," Nitsure said.

But most bankers said they don't expect any depreciation if the yields remain stable at current levels. "These views have resulted in the resurgence of state-owned banks," a dealer said.

Punjab National Bank Chairman and Managing Director S.C. Gupta said the bank made provisions worth Rs 3.86 billion in April-June quarter, but he doesn't expect any provisions for July-September, if the yield remains stable.

Support of state-owned banks is a psychological boost to the gilt market, a private bank dealer said. "Good days will be back if they stay long enough."