Veterans in the Indian financial markets will remember the term credit-deposit wedge. It has in the past been regularly used to describe a situation where the banking system deposit growth is unable to keep pace with credit growth.

So what gives in such a situation? It used to be the investment book of the banks. Banks used to wind down their excess statutory liquidity ratio (SLR) to fund the credit growth that is in excess of the deposit growth. Let us look at the situation in the current year.

The total deposit accretion for the banking system to date is around Rs 6.8 trillion while the overall loan book has gone the other way by actually falling Rs 1.45 trillion. On top of that, we have banking system liquidity in a comfortable surplus due to RBI’s pro-active measures on liquidity and significant FX inflows. So what takes? The investment book of the banks! In an exact mirror image of the earlier situation, bank SLR book in the current year to date has grown by Rs 6.6 trillion leading to a much higher marked-to-market risk on the balance sheets of the banks.

Any further increase in the borrowing would have further accentuated the above problem for banks. There was a fear in the market that the government will have no option but to announce higher market borrowings in the wake of falling tax collections and uncertainty on the finalisation of the framework for GST cess compensation for the State Governments.

In this respect the announcement of the borrowing calendar was a huge relief for the market as not only did the Government stick to the original borrowing program for the year but they have also adjusted the second half borrowing by the amount of green-shoe option that they exercised in the first half borrowing calendar. This has led to a relief rally in the bond markets.

The unchanged borrowing program would lead to weekly auction size of ~Rs 270-280 billion. Moreover, the positive surprise from state governments' borrowing calendar for Q3 which came in much lower than market expectations, would aid sentiment and could lead to some spread compression in State Development Loans (SDLs). The T-bill calendar has also seen a sharp tapering in weekly supply compared to the previous quarter. If the same rate is maintained in the last quarter as well, then the government borrowing from short-end could be ~Rs 1 trillion for the year, which can be easily refinanced next year.

In addition to the tailwinds from the borrowing announcements, some other factors that remain positive for the bond markets are 1) system liquidity remaining in adequate surplus 2) credit-offtake continuing to remain low, which could in turn mean that banks have no option but to buy more government bonds 3) forward guidance of the RBI/MPC to remain accommodative. Given these positives, and given that the uncertainty of the borrowing program is now out of the way, yields could find space to soften a bit going forward.

The tenor wise allocation of the borrowing program is also interesting with a lower allocation in the 10-14-year segment and higher allocation in longer end bonds as compared to what was seen in H1. This along with expected RBI intervention could assist in providing some relief in the belly of the curve, but we could see some steepening in the long end of the curve.

However, one has to balance the positives with some concern areas as well. The average size of weekly auction from both centre and state combined still remains on the higher side and similar to H1 and further reliance on green-shoe option cannot be ruled out for both. Concerns also arise from the fact that most analysts estimate fiscal deficit close to 8.0 percent of GDP on the back of both revenue slippages and a contraction in GDP leading to both the numerator and the denominator effect.

We expect the center to use other sources of financing the fiscal deficit including external funding, short-term borrowing and cash-draw down components in order to cushion the impact. However, on a net basis we still expect the center to borrow extra of around Rs 1 trillion during the last 2 months of this financial year. This might be one of the reasons that the central government borrowing program is scheduled to be wrapped up January end.

To summarise, the unchanged borrowing program could lead to some short-term relief in the near term though some nagging doubts around continued supply will remain.

On monetary policy, markets will watch closely the announcements of the new external members and their proclivities and dispensations towards growth and inflation. The uncertainties around the trade-off between growth and inflation continue, (though in our, view growth concerns will need to overshadow inflation concerns going ahead).

This would be assisted by our and MPCs expectations of a lower trajectory of inflation assisted by base, robust food grain production and lowering momentum in oil prices, even as growth is expected to remain muted. Given these factors, we maintain our view of a Repo rate pause in Q3, with a possible rate cut in Q4 of 25 bps, when there is clarity on inflation moving close to RBI/MPC's comfort zone.

Markets will continue to expect RBI to intervene through demand inducing measures to absorb government paper. Moreover, given the demand/supply scenario, we feel that that the 10-14-year segment should outperform the rest of the curve.

(The author is Group Head - Global Markets - Sales, Trading and Research, ICICI Bank)

First Published:Oct 1, 2020 4:10 PM IST