Bond yields and prices move in opposite direction. This means that if the yields rise, bond prices decline, and in case the current price of bonds is lower than the price at which they were acquired, banks need to book depreciation, or MTM, losses. They can escape this if their entire bond holding is kept under the so-called held-to-maturity, or HTM, category, and many Indian banks are pushing for it.
Under current norms, they are required to invest 24% of their deposits in government bonds, down from 25% a year ago. But up to 25% of deposits invested in bonds can be kept under the HTM category. Then why do they need to book depreciation losses in case bond yields go up? Well, the overall bond holding of Indian banks is now much higher than the stipulated 24% of their deposits; it is around 28%.
This is because of the government's massive borrowing programme. The government plans to borrow a record Rs4.51 trillion from the market to bridge a fiscal deficit that is estimated at 6.8% of gross domestic product, or GDP.
In the February interim budget, finance minister Pranab Mukherjee had projected Rs3.62 trillion of market borrowing by the government in fiscal 2010, through its investment banker Reserve Bank of India, or RBI. At that time, the fiscal deficit for the year was estimated to be 5.5% of India's Rs54.3 trillion GDP.
In the first half of the fiscal year, RBI borrowed Rs2.95 trillion from the market. It will borrow Rs1.23 trillion in the second half. The rest, Rs33,000 crore, is being generated by transferring RBI's intervention bonds to the government.
These bonds were floated between 2004 and 2007 under the Market Stabilisation Scheme, or MSS, to soak up excess liquidity that was created because of RBI's intervention in the foreign exchange market. The central bank was buying dollars to check the rupee's appreciation because a strong local currency hurts exporters. For every dollar that RBI bought, an equivalent amount of rupees flowed into the system and the central bank sucked out the excess money through MSS bonds.
There are three categories of bonds in a bank's bond portfolio--HTM, available for sale (AFS) and available for trade (AFT). While bonds kept under HTM are not affected by volatility in interest rates, banks need to provide for depreciation of bonds kept under the other two categories. RBI is reportedly considering a proposal to raise the HTM limit, and the 10-year benchmark bond yield dropped almost 0.5 percentage point from the second week of September to close to 7% by the end of the month after RBI officials made public announcements on this. If indeed the central bank decides to raise the HTM limit, it will be able to protect bank balance sheets from the impact of rising rates and also push down the yield on bonds, but this will deal a blow to the credit market.
Banks have two avenues to park money--buying bonds or keeping it with RBI. While the average cost of incremental deposits is around 5.5-6%, banks can earn 3.25% by keeping money with RBI or around 7% by buying bonds. Right now they need to make the risk-return analysis while choosing between the RBI window and buying bonds but once the HTM limit is raised, they will be tempted to buy more bonds for risk-free higher returns. So, the HTM limit should not be raised.
Starting April 2011, Indian banks will shift to International Financial Reporting Standards and have the freedom to decide how much of their bond portfolio will be kept in the HTM category. There will be no cap on any of the categories, but the boards of banks will decide at the beginning of every year to what extent they can sell bonds kept in the HTM category, and the banks will have to stick to that.
Tamal Bandyopadhyay keeps a close eye on all things banking from his perch as Mint's deputy managing editor in Mumbai.
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