Banks voice concerns over rupiah, floating rate notes ahead of RBI policy

In interactions last week with senior Reserve Bank of India officials, some banks commented on two main concerns in the bond market, namely the recent volatility in the rupee-dollar exchange rate and the heavy losses suffered on floating-rate government bonds due to a demand-supply mismatch, sources told Business Standard.

The talks took place ahead of the RBI’s next monetary policy statement, due on August 5.

Indian banks are large holders of government securities due to a regulatory mandate to set aside a certain percentage of deposits in sovereign bonds.

In recent years, banks have purchased bonds above the prescribed amount as a historically low interest rate regime and comfortable liquidity have driven bond yields lower. Bond prices and yields move in opposite directions.

In the previous quarter, however, banks suffered losses on their debt portfolios as RBI rate hikes to tackle high inflation led to a sharp rise in sovereign bond yields. The losses incurred on bond investments weigh on the profitability of banks.

“There were some discussions on Thursday – some of it was purely operational and related to demand and supply issues in the market. In the other, the market was asked about the big concerns at the moment,” said a source familiar with the developments.

“As for the short-term path of inflation and interest rates, the market knows that rates will be raised because it will take a long time for inflation to return to target. The volatile factor in the ‘equation is the rupee, because if we have another episode of significant weakness, the RBI may need to consider rate action to maintain interest rate differentials (with advanced economies) and protect the rupee’, the source said.

Over the past month, the Indian currency has seen significant turbulence against the US dollar as a global wave of risk aversion and the likelihood of aggressive rate hikes by the Federal Reserve have prompted investors around the world heading towards the largest economy in the world.

The rupee, which on July 21 hit a new low of 80.06 per US dollar, has weakened 6.9% against the greenback so far in 2022. The depreciation in the past month alone was 1.9%, according to Bloomberg data. The U.S. dollar index, which measures the U.S. currency against six major rival currencies, has strengthened 11.5% so far in the calendar year.

The weakness of the rupee was cited as a key factor which prevented foreign investors from buying Indian bonds. A weaker rupee erodes foreign investors’ domestic asset returns.

While the RBI has so far fiercely protected the rupee from excessive volatility by selling greenback from its reserves, market participants have been concerned about whether the central bank may have to use interest rates. higher interest as a defense in case of a new crisis in the national currency.

“From a market perspective, the main concern is the currency. So far, RBI has put up a formidable defense with its reserves, but it may need to ensure that the rate spread remains wide enough. If rates are not raised, term premia go down, speculation increases,” another source said.

The RBI, which has raised rates by a total of 90 basis points since May 4, is expected to raise the repo rate by 30 to 50 basis points next month. The US Federal Reserve, which has raised benchmark interest rates a total of 150 basis points since March, is expected to announce another 75 basis point hike later this week.

Floating rate bonds

Operationally, a key issue signaled by the market has been the recent heavy losses on floating rate papers as the large supply of these papers hit the market at the weekly government bond auctions. .

The government usually holds an auction every Friday where it sells bonds and raises funds.

According to its dated bond issuance schedule, the government is holding auctions worth Rs 4,000 crore of aligned floating rate bonds every fortnight until the end of September.

“There was initially good demand for FRBs because they act as a hedge in a rising interest rate scenario and they don’t pose duration risk on bond portfolios. But the supply that came in became very concentrated and the price of these bonds fell much more than it should have.The market asked for a lower supply,” the first source said.

Over the past five months, the price of the government’s most widely issued floating-rate bond at its weekly auctions has plunged more than three rupees, leading to heavy mark-to-market losses on bond portfolios.

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