The Rs 2.11 trillion bank recapitalisation plan and the Rs 6.92 trillion road construction plan entails huge supply of bonds. Supply whether direct or indirect will hit bond yields as both these plans lead to higher economic activity that could exert higher inflation expectations down the line. Ten year benchmark gsec yields are trading at levels of 6.80% and given that there are no positives round the corner for the bond market, the yield will trend higher in the coming weeks.
On the 24th of October 2017, the Central Government announced a Rs 2,100 billion capital infusion plan for PSU banks and the largest ever highway construction plan to develop approximately 83,677 km of roads by 2022 with an investment of Rs 6,920 billion to boost the economy. This move comes after India’s GDP growth rate fell to 3 years low at 5.7%, which is well below the levels needed to create jobs for the economy to sustain itself. Central Government has tried to step up public spending for growth and has already exhausted 96.2% of the fiscal deficit target for FY-18, making it essential that private investment picks up.
Government will capitalise PSU banks in a front-loaded manner with a view to support credit growth and job creation. Capitalisation will be done through budgetary provisions of Rs. 181.39 billion and issuance of recapitalisation bonds of Rs 1350 billion. The balance portion of funds will be raised through raising of capital by banks from the market while diluting government equity (estimated amount Rs. 580 billion).
The bond market is factoring the banks to subscribe to the recapitalisation bonds and the government will use the funds raised from banks to infuse equity into the banks. Deposits get converted to equity and banks will leverage on equity to grow credit, leading to a money multiplier effect that will pull up economic growth through higher demand, both investment and consumption demand.
Given a cash neutral and market supply neutral view of the recapitalisation plan, bond markets have not sold heavily and the 10 year gsec yield rose by just 4bps week on week to close at levels of 6.80%. However, if the recapitalisation bonds are given SLR status, banks will not have any appetite for incremental buying in government bonds and this could hurt demand supply equations in the bond market. Banks holding of government bonds at around 31% of NDTL is well over SLR limits of 19.5%.
Even if the bonds do not carry SLR status, they will have to be marked to market and if growth and inflation pick up, the bond prices will be marked down leading to losses for banks. The recapitalisation bonds will carry long maturity and will be highly sensitive to rate movements.
Projects under Bharatmala Phase-I are to be implemented through NHAI, NHIDCL, MoRTH and State PWDs. Gross Budgetary Support for the Bharatmala program and existing schemes from 2017-18 to 2021–22 will be Rs. 2370.24 billion from Central Road Fund (CRF), Rs 599.73 billion as Budgetary support, Rs. 340 billion from expected monetization through ToT (toll-operate-transfer) route and Rs. 460.48 billion collected as Toll-Permanent Bridge Fee Fund (PBFF) by NHAI. Rs.2090 billion will be raised as debt from the market, Rs.1060 billion of private investments would be mobilized through PPP.
Evenly distributing Rs 2090 expected market borrowing over next 5 years, yearly borrowing will be Rs 418 billion. Out of the Rs 180 billion for bank recapitalisation budgetary support this year, Government has already set aside Rs 100 billion for this fiscal year. Hence, this year market can see additional Rs 498 billion bonds supply. Though system liquidity, is high market will be cautious while absorbing this supply.
RBI is also selling bonds through OMO, adding to the supply. RBI has sold Rs 800 billion of bonds in this fiscal year and has announced a sale of Rs 100 billion on the 9th of November. As per RBI for the second half 2017, SDL supply is expected to be in the range of Rs 2331 billion to Rs 2440 billion.
Government bond yields rose last week on the back of supply fears. The 10 year benchmark bond, the 6.79% 2027 bond saw yields rise by 4bps to levels of 6.80%. The on the run bonds, the 6.79% 2029 bond and the 6.68% 2031 bond saw yields rise by 4bps and 5bps respectively to close at levels of 7.04% and 6.98%. The lon bond, the 7.06% 2046 bond saw yields rise by 3bps to close at levels of 7.31%. Government bond yields will rise on supply fears.
OIS yields rose on the back of rise in government bond yields. 1 and 5 year OIS yields rose by 5bps and 11bps respectively to close at levels of 6.16% and 6.38%. OIS yields will rise on bond supply fears.
5 and 10 year AAA corporate bond yields rose by levels of 3bps and 7bps respectively to close at 7.19% and 7.55%. Credit spreads fell for 5 year bonds by 3bps at 39bps and rose for 10 year bonds by 3bps at 70bps. Credit spreads will be sticky at higher levels though 5 year spreads could rise as markets arbitrage with 10 year spreads.
System liquidity as measured by outstanding Repo, Reverse Repo, MSS and CMB Bonds and MSF was at Rs 2019 billion as of 27th October 2017 against levels of Rs 1852 billion as of 20th October 2017. Currency in circulation has risen by Rs 650 billion over the last one month on the back of festive season demand for funds. Liquidity will rise on the back of government spending.