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Debt markets: Liquidity concerns

Sep 18, 2001

The Indian debt markets are witnessing volatile activity since the past few days due to devaluation in the Indian currency. This has created uncertainty in the gilt price movements. The rupee touched a new low of 48.83 to a dollar before recovering sharply to close at 47.75. Persistent dollar demand from the foreign funds and importers pulled down the rupee to a new low. The RBI’s intermediation through pumping US$ 165 - $ 175 m into the markets led to some recovery in the Indian currency.

With a volatile forex markets, gilt prices are also reflecting a similar trend. The 10-year yield curve had moved up to 9.63% on September 17, 01 from 9.18% on September 10, ‘01. Heavy sell off by domestic mutual funds contributed to fall in gilt prices across all maturities. For the first time since the beginning of the year 2001, mutual funds were net seller in the debt markets to the tune of Rs 2 bn cumulatively for three consecutive days (since September 12, ’01).

However, RBI’s announcement that it will carry open market operations to inject liquidity in the debt markets lifted sentiment. Gilt prices managed to recover towards the close. The Central Bank will purchase four government securities (G-Sec) through an auction from September 18, 2001. However, with equity markets trading at historic lows, mutual funds are likely to reshuffle portfolio in order to maximize the return. This could lead to range bound movements of gilt prices in the near term.

Meanwhile, central bankers in both the US and Europe have announced an interest rate cut of 50 basis points. This is to infuse liquidity in the system. Already, the Federal Reserve, ECB, Bank of Japan and Swiss National Bank have provided billions of dollars to ensure liquidity in the world banking system and to fuel investor sentiment. With this rate cut, the federal fund rate now stands at 3% and European Central Bank’s (ECB) interest rate stands at 3.75%.

Back to India the bank rate is still higher at 7%. Although, the RBI has indicated softer interest rates going forward in the near term it is unlikely. This could be due to continuous devaluation of the rupee on the back of increasing outflow by foreign funds. The US based funds are reportedly repatriating funds back to their home markets on liquidity concerns in the Indian markets. The government’s decision to increase the FII limit in Indian companies to 74% from the earlier 49% could however, offer some relief.

Notwithstanding these concerns, the outlook for the Indian debt market remains bright considering the comparatively higher interest rates compared to US and Europe. The only concern is liquidity, which would also improve as the markets mature. Also, in the short term the volatility in the debt markets would cast a shadow on banking companies. Banks are required to make mark to market provision on their investment portfolio, which is held for trading. If gilt prices decline, banks’ provisions for diminution in value of investments will increase, consequently eroding profits.

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