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Relapse of G-sec yield curve steepening; private lenders ahead in the cyclical upturn

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Mr.Dhananjay Sinha

Head of Research, Economist & Strategist

22 Nov 2017

The sharp decline in the benchmark 10-year G-sec yield to 6.40% in Jun’17 was contributed by transitory factors such as the lingering impact of demonetisation (Nov 2016) and GST dislocations. These factors led to a sharp decline in credit demand and unprecedented excess systemic liquidity of 3.5-4.3% of bank deposits, overriding the influence of the recent rise in commodity prices and shift in RBI’s monetary policy stance from ‘accommodative’ to ‘neutral’. Cumulatively, these two factors may have contributed a little over 100bps of the 160bps decline in 10-year G-sec yield since Feb’16 level of 8%.

However, this aberration is at the cusp of a significant normalization. The recent reversal in yields with the 10-year moving back to 7% is not surprising. But, clear signs are now emerging that the temporal factors behind the flattening of G-sec curve (during mid-2016 to mid-2017) are reversing conclusively.

Reversal in some of the domestic indicators such as revival in credit growth, decline in systemic excess liquidity, still leveraged banking system, increased supply of government debt and resurfacing of inflationary pressure have reinforced our earlier conviction on the possibility of the 10-year G-sec yield rising to 7.5-7.8% in the next 6-12 months from the current level of ~7%.

In view of the domestic factors and declining global excess liquidity, there is sufficient scope for the reversal of the 25bps reduction in repo rate announced by RBI in Aug’17 and review of its ‘neutral’ policy stance in FY19. Possibility of declining short-term liquidity, along with the reversal of the 25bps reduction in RBI’s repo rate in April’17 to 6% can also push up yields at the shorter end.

Importantly, the inflation trajectory is expected to move higher. Multiple factors are likely to drive future inflation: a) rise in global commodity prices, b) receding negative domestic growth shocks, c) emergence of fiscal multiplier effect of large government spending and d) potential INR/USD depreciation due to strong USD view. In the next 6-9 months, CPI inflation could be above 5%, higher than RBI’s end-FY18 expectation of 4.2-4.6%. Core CPI inflation is expected at ~5.3% by Mar’18. In this scenario, RBI can abandon its ‘neutral’ stance in FY19 and move towards some tightening.

Simultaneously, the cyclical upturn in bank credit demand on the back of higher household leveraging, revival of working capital demand and improved lending ability of public sector banks (PSB) are expected to push up credit growth to 12-13% from a 6-decade low of 5% struck in Mar’17. Deposit growth is likely to moderate to 8-10% in H2FY18 due to higher base from last year’s demonetization. Hence, the rise in credit-deposit ratio to 74-75% by Mar’18 will reduce the appetite for G-secs.

However, we observe that notwithstanding the decline in credit demand, the total deployment of funds by banks across lending, investments in G-sec and cash has remained above 108% of bank deposits. Therefore, rising credit demand will exert pressure on banks to reduce excess G-sec holdings, thereby increasing yields.

Simultaneously, the supply of government papers is expected to rise on account of farm loan waivers and PSB recapitalization proposal. These will contribute to the reflationary fiscal stance adopted by the government.

From global stand point, the best phase of excess liquidity is behind us, as major central banks sustain the normalization process following a decade long ultra-accommodative stance adopted since 2008.

Hardening of US treasury yields on the back of expected Fed rate hikes and tapering of the Fed’s balance sheet will also impart pressure on Indian G-sec yields. Our estimates suggest that in the backdrop of improved economic data points, the US Fed rate should already be more than 2%. Better growth in the developed economics forebodes a supportive backdrop for the emerging economics, including India. However, the Fed’s normalization and sympathetic responses from other central banks will imply tightening in global excess liquidity and stiffer financial market conditions.

While upturn in credit demand will be beneficial for India’s banking and lending sector, the hardening of G-sec yields can expose several of them to risk. Demonetization and disruptions related to GST implementation induced a sharp influx of liquidity into the banks. This contributed to the rapid increase in SLR holdings (G-sec) with the banks, leading to trading gain bounties when the G-sec yields had declined sharply earlier. Over the last 1.5 years, treasury gains for several PSBs contributed close to 100% of PBT. Hardening of the G-sec yields is now likely to convert these treasury gains into losses.

Overall, revival in credit demand portends improving outlook, but well capitalised banks with stronger asset quality, primarily private banks, will continue to gain market share aggressively. PSBs’ performance will depend on their ability to grow higher than the industry rate and more profitably. While the Rs2.11tn recapitalisation program announced by the government for the next two years is intended to address the credit risk, it is still inadequate (a third of impaired assets), and definitely not enough to provide significant growth capital. Hence, better capitalized private banks are ahead of the PSB pack even in a cyclical revival scenario. NBFCs, specially the Housing Finance Companies will likely see elevation in their cost of funds, which along with intensifying competition will impart margin pressure.