Banks flag concerns on rupee, floating rate bonds ahead of RBI policy

The discussions were held ahead of the RBI's next monetary policy statement, scheduled August 5

At interactions last week with senior officials from the Reserve Bank of India, select banks gave feedback on two key bond market concerns, namely, recent volatility in the rupee-dollar exchange rate and heavy losses incurred on floating rate government bonds due to a demand-supply mismatch, sources told Business Standard.

The discussions were held ahead of the RBI’s next monetary policy statement, scheduled on August 5.

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

Over the past few years, banks have bought bonds over and above the mandated quantum as a regime of record low interest rates and comfortable liquidity have seen bond yields drop. Bond prices and yields move inversely.

In the previous quarter, however, banks suffered losses on their debt portfolios as rate hikes by RBI to tackle high inflation caused sovereign bond yields to rise sharply. Losses suffered on bond investments dent the  profitability of banks.

“There were a couple of discussions on Thursday – one part of it was purely operational and about demand-supply concerns in the market. In the other one, the market was asked about broad concerns at the moment,” a source aware of the developments said.

“When it comes to the near-term trajectory of inflation and interest rates, the market knows that rates will be hiked as it will take a long time for inflation to come back to target. The volatile factor in the equation is the rupee, because if we have another bout of significant weakness, the RBI may have to consider rate actions to maintain the interest rate differentials (with advanced economies) and protect the rupee,” the source said.

Over the last month, the Indian currency has witnessed substantial turbulence versus the US dollar as a global wave of risk aversion and the likelihood of aggressive rate hikes by the Federal Reserve has prompted investors worldwide to make a beeline for the world’s largest economy.

The rupee, which on July 21, marked a fresh low of 80.06 per US dollar, has weakened 6.9 per cent against the greenback so far in 2022.  The depreciation in the past month alone has been 1.9 per cent, Bloomberg data showed. The US dollar index, which measures the American currency against six major rival currencies, has strengthened 11.5 per cent so far in the calendar year.

The rupee’s weakness has been cited as a key factor that has prevented foreign investors from purchasing Indian bonds. A weaker rupee erodes overseas investors’ returns from domestic assets.

While the RBI has so far fiercely shielded the rupee from excessive volatility through sales of the greenback from its reserves, market participants expressed concern over whether the central bank may have to use higher interest rates as a defence in the event of another bout of turbulence in the domestic currency.

“From a market point of view, the biggest concern is the currency. RBI has put up a formidable defence through its reserves so far but it may have to ensure that the rate differential remains wide enough. If rates are not hiked, forward premiums fall, speculation increases,” another source said.

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

Floating rate Bonds

On the operational side, a key issue flagged by the market was the recent heavy losses incurred on floating rate papers because of heavy supply of such papers hitting the market through weekly government bond auctions.

The government typically conducts an auction every Friday through which it sells bonds and raises funds.

According to its calendar for issuance of dated securities, the government has auctions worth Rs 4,000 crore of floating rate bonds lined up on a fortnightly basis till 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 books. But the supply that came in became very concentrated and the price of these bonds fell much more than they should have. The market has requested for lower supply,” the first source said.

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