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Nomura Sees Rates Backfiring on Auction-Flop Costs: India Credit

Nomura Sees Rates Backfiring on Auction-Flop Costs
A vendor holds Indian rupee notes at his store in the Dadar wholesale flower market in Mumbai. Rupee denominated bonds returned 2.79 percent this year, still Asia’s second-best performance after Philippine debt, according to HSBC Holdings Plc indexes. Photographer: Dhiraj Singh/Bloomberg

The Reserve Bank of India’s surprise policy reversal and the first government debt-sale failures in 10 months prompted Nomura Holdings Inc. to warn that plans to cut the budget deficit are at risk.

Underwriters had to pick up 24 percent of the 150 billion rupees ($2.5 billion) of bonds offered at a July 19 auction after demand fell short. India didn’t sell any of the 120 billion rupees of bills it offered on July 17 and, a day earlier, state governments met only 26 percent of their borrowing target at a separate sale. Demand slumped after the RBI raised two of its interest rates on July 15 to arrest a slide in the rupee.

Policy tightening by the RBI, which cut interest rates as recently as in May, will cool growth in Asia’s third-largest economy that is already expanding at the slowest pace in a decade and strain public finances, according to Nomura. Ten-year bond yields in India have jumped 86 basis points to 8.11 percent since May 31, increasing costs for a government that spends about 35 percent of revenue servicing its debt. Similar rates climbed 32 basis points to 3.78 percent in China.

“The combination of tight liquidity and low growth are expected to persist and will probably be the most prominent feature of the current economic cycle,” Vivek Rajpal, a Singapore-based strategist at Nomura, Japan’s biggest brokerage, said in a telephone interview yesterday. “The rates markets are currently being held hostage by the currency markets.”

Inter-Bank Funds

The rupee’s 8.6 percent slide against the dollar last quarter, the worst performance in Asia, prompted the RBI on July 15 to raise the two rates and cap lending through its daily repurchase auctions at 750 billion rupees ($12.6 billion). The central bank kept its benchmark rate unchanged.

The measures pushed up the inter-bank lending rate to an intraday high of 9.25 percent on July 16 and 17, a level unseen since Dec. 31. Three-month commercial-paper rates have surged 136 basis points since July 15. They touched 10.43 percent on July 16, their highest level since April 2012.

Ten-year government bonds slumped the most since 2009 on July 16, a day after the tightening measures were announced, with the yield touching a seven-month high of 8.10 percent.

“The jump in rates is a negative for the government in terms of debt-servicing costs and the fiscal outlook,” Dariusz Kowalczyk, a strategist at Credit Agricole CIB in Hong Kong, said in a telephone interview yesterday. “The price the authorities are paying for the stabilization of the currency is very severe, and I don’t think they wanted that.”

Food Subsidy

Prime Minister Manmohan Singh, facing elections by May, decreed a Food Securities Bill that vows to provide cheap food for the poor at a cost of $21 billion a year. For a government that aims to cut its budget deficit to a six-year low of 4.8 percent of gross domestic product this financial year, Nomura predicts this spending may boost food subsidies to as much 1.2 percent of GDP annually from 0.8 percent.

The administration plans to spend 5.3 trillion rupees on debt servicing in the fiscal year to March, or 22 percent more than a year ago, according to budget documents. About 3.7 trillion rupees are earmarked for interest payments and 1.67 trillion rupees for repayment of debt.

The government will find it “challenging” to meet its budget goal without slicing spending, Nomura predicts.

Finance Minister Palaniappan Chidambaram is under pressure to rein in the gap after Standard & Poor’s last year cut the sovereign credit outlook to negative and a step closer to a junk rating. The RBI’s measures last week don’t signal a shift toward a tightening bias, he said in Moscow on July 20, while his adviser Raghuram Rajan said they were temporary.

Waiting Mode

While an interest-rate increase is not on the cards, the monetary authority may consider raising banks’ cash reserve requirements should the rupee threaten to depreciate further, according to DBS Bank Ltd.

“The finance minister has always stressed the need for more accommodative monetary policy as opposed to a more cautious RBI, so this divergence remains,” Radhika Rao, an economist at DBS in Singapore, said in a telephone interview yesterday. “The recent squeeze in yields seems to have surprised the RBI, so it may be on a wait-and-watch mode.”

Four days after the RBI raised the marginal standing facility and the bank rates to 10.25 percent from 8.25 percent, primary dealers had to buy 35.3 billion rupees of the planned 150 billion rupees of bonds at the auction. Two days earlier the RBI rejected all the bids at an offering of treasury bills.

The yield on the benchmark 7.16 percent note due May 2023 rose two basis points to 8.11 percent as of 9:48 a.m. in Mumbai, and the rupee advanced 0.2 percent to 59.625 per dollar.

Looking Good

Indian bonds offer good value at current levels, according to Royal Bank of Scotland Group Plc and IDBI Bank Ltd. The 10-year sovereign bond, which offers 561 basis points over similar-maturity U.S. Treasuries, may yield 7.90 percent in about 10 days, N.S. Venkatesh, head of treasury at IDBI Bank in Mumbai, said on July 17.

“On the likely assumption that the rupee would stabilize, we believe that the RBI could start lowering the policy rate possibly from September,” Sanjay Mathur, head of research and strategy at RBS in Singapore, wrote in a research report yesterday. “Bond yields are set to moderate. The process is likely to be slow but nonetheless rewarding.”

Rupee-denominated bonds returned 1.59 percent this year, Asia’s third-best performance after Philippine and Chinese debt, according to HSBC Holdings Plc indexes.

Credit Risk

Credit risk has surged as the currency declined. Five-year credit-default swap contracts insuring the debt of government-controlled State Bank of India, considered a proxy for the sovereign, rose to 242 on July 19 from this year’s low of 174 on May 17, according to data provider CMA.

The RBI’s steps to bolster the rupee will “negatively affect” growth if high market rates persist, Moody’s Investors Service said yesterday. On July 19, Nomura cut its growth estimate for the $1.9 trillion economy to 5 percent in the current financial year from 5.6 percent, and matching last year’s decade-low.

“These measures necessarily intensify downside risks facing the economy,” Richard Iley, chief Asia economist at BNP Paribas SA in Singapore, wrote in a July 17 research note. “Unless they are temporary, they risk backfiring.”

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