213) Should the RBI hike the SLR?

An SLR hike will immediately translate into a rise in the demand (from banks) for government bonds, says Abheek Barua.

My colleague, Amit Dayal — astute money manager, foodie and recent convert to gym-ming — has come up with what seems like a pretty smart way to counter the upward pressure on bond yields. But before I get to the specifics of his suggestion, let me start with a bit of a prelude.

In the second half of 2008, the markets viewed expansionary fiscal policy as a deus ex machina that would lift it out of its funk. Ironically enough, as a number of government exchequers obliged by loosening their purse strings and President Obama handed out the mother of all fiscal packages, the market suddenly woke up to the fact that these fiscal steps entailed significant costs.

As governments turned to the bond markets to fund their fiscal binge, bond yields rose sharply and now threaten to stall lending rate reductions. In India, for example, the 10-year bond yield has risen by a hefty 160 bps between the low of early January and the level today. This has been in response to the huge additional government borrowing — Rs 46,000 crore for the current year despite which there is a fiscal hole of Rs 45,000 crore. The government is now filling this hole by transferring money locked up in Money Stabilisation Bonds (MSS).However with the stock of MSS dwindling fast it might not have that option next year. The central government incidentally needs to pick up at least Rs 3,70,000 crore from the market in the next fiscal, going by the calculations in the interim budget.

The fear of government ‘crowding out’ private spending might appear, at least at this stage, a tad irrational. Private credit demand is collapsing as the recession intensifies and government demand is likely to fill the void left behind. Thus neither yields nor interest rates should necessarily harden in the near term even if the government guzzles funds. Should the market rest easy then?

Perhaps not. For any forward-looking investor, the longer-term consequences of a fiscal bloat are difficult to ignore. For one, while it is easy to run up a large deficit very quickly, they are difficult to tame. A large deficit entails high interest costs for the government that feed the fiscal gap leading to more borrowings. In short, the government is likely to remain a large borrower for a good few years if there is a large fiscal overrun now. The implication — whenever private credit demand picks up, the competition from the public sector would push borrowing rates up and stymie growth. This anxiety is getting reflected in high government yields.

Is there a way to handle the increased government draft on resources without pushing rates up? Monetary policy rates at close to zero in the developed markets rule out further rate action; the only option for central banks would be to keep buying back government bonds, which de facto means monetising the fiscal deficit. Amit suggests that the impact of government borrowings can be handled better in India than in other markets. This is essentially because of the unique monetary device that we have called the statutory liquidity ratio or SLR (the fraction of the banks’ aggregate liabilities that they are mandated to hold in government securities). It is currently at 24 per cent.

The crux of Amit’s argument is the following — instead of focusing entirely on shoring up the supply of liquidity to check bond yields, the government might be better off in trying to best push up what he calls the ‘inherent demand’ for government bonds. If there is no inherent demand, he argues, growing supplies of bonds will keep pushing yields up. The easiest way to increase this ‘inherent demand’ is by hiking the SLR. This will immediately translate into a rise in the demand (from banks) for government bonds; as banks are forced to buy bonds, bond prices will move up and bond yields would head down. A 1 per cent increase in the SLR, incidentally, yields additional demand for government bonds of roughly Rs 40,000 crore.

What are the advantages of this somewhat unorthodox strategy? If bond yields come down, the government borrows at a lower average cost. This could dampen the fiscal spiral that high interest bills set off. Banks stand to make marked-to-market gains on their bond books and this could give them a cushion to absorb the costs that could follow from a rise in non-performing loans that are likely to rise in a downturn. The RBI, in its avatar of merchant banker to the government, can push through the government borrowing programme more easily.

A policy involving an increase in the government’s draft on funds in the middle of a slowdown might seem a little counterintuitive. However, if you follow Amit’s logic through, it appears to make sense. For one, the governments will remain the bigger provider of demand in a business cycle trough and the sensible thing to do is to ensure that their access to funds is easy and comes cheap. An SLR increase ensures this.

Are banks likely to worry about the impact on liquidity that a hike in SLR entails? Could this affect the flow of credit to the non-government sector? The way around this, Amit argues, is to provide refinance to banks against the entire additional stock of SLR that they need to hold. If liquidity does tend to tighten a little, banks can turn to this window to access liquidity. The refinance could come at the repo rate. If the RBI wants to signal lower cost of funds, it needs to cut the repo rate.

What happens as the economy starts picking up and private borrowers need more credit? The RBI would have to reduce SLR to accommodate this and this could potentially spike yields up. Amit accepts that while this could potentially lead to marked-to-market losses on banks portfolios, there could be a few offsets. Economic recovery is likely to coincide with an improvement in government finances. If indeed the government borrows less incrementally, the impact of a reduction in SLR on bond yields need not be sharp.

Amit mailed me a note on this titled ‘Wild Thoughts’. Perhaps his thoughts are not so wild after all. I wonder what Dr Subbarao would have to say.

The author is chief economist, HDFC Bank. The views here are personal

212) Are we going to face problems of deflation?

Nowadays we keep on reading that global economies such as US and Europe will face severe problems of deflation due to recession. Fed fund rate in the US is between 0.00-0.25% or 25 bp (100 basis point = 1%). Inflation in these countries is close to 0. With the falling interest rates in India will we too face similar situation?

Deflation is a “sustained” fall in the general price level of goods and service below zero percent inflation. It results in an increase in the real value of money — a negative inflation rate. It is just opposite of inflation, which is the general increase in the price level of goods and services. When the inflation rate slows down (decreases, but remains positive), this is known as disinflation. Disinflation is a substantial drop in the rate of increase of the price level. Deflation should not be confused with temporarily falling prices; instead, it is a sustained fall in general prices.

Inflation destroys real value in money whereas Deflation creates real value in money. 

               Real Price ~ Nominal Price –Inflation

With the passage of time, the “real price” of any good or service is characterized by above equation. Hence, if it is positive inflation or normal inflation, real price decreases over a period of time. However, if inflation is negative i.e. deflation, real price increases with time. Alternatively, the term deflation was used by the classical economists to refer to a decrease in the money supply and credit.

Causes of deflation

1. Deflation is caused by the fall in aggregate level of demand i.e. there is a fall in how much the whole economy is willing to buy, and the going price for goods. Because the price of goods is falling, consumers have an incentive to delay purchases and consumption until prices fall further, which in turn reduces overall economic activity - contributing to the deflationary spiral. (As we can currently see that buyers believe real estate prices will fall further, thus delaying their purchase decisions. This in turn has reduced the demand for the real estate properties which in turn has reduced the construction activities. Thus, general economic activities such as cement production etc are down.)

As demand and economic activity falls, investments fall as well because corporate do not want to invest in increasing capacity as there is no demand. This leads to further reduction in aggregate demand. This is the deflationary spiral i.e. a situation where decreases in price lead to lower production, which in turn leads to lower wages and demand, which leads to further decreases in price. An answer to falling aggregate demand is stimulus, either from the central bank, by expanding the money supply, or by the fiscal authority to increase demand such as reducing interest rates or giving money to corporate or people at significantly lower rates.

2. In monetarist theory, deflation is related to a sustained reduction in the velocity of money (It is the average frequency with which a unit of money is spent in a specific period of time. Velocity affects the amount of economic activity associated with a given money supply) or number of transactions. This is attributed to a dramatic contraction of the money supply, perhaps in response to a falling exchange rate, or to adhere to a gold standard or other external monetary base requirement. In the present scenario it appears to be one of the prime reasons for growing fears of deflation.

3. Deflation also occurs when improvements in production efficiency lower the overall price of goods. Improvements in production efficiency generally happen because economic producers of goods and services are motivated by a promise of increased profit margins, resulting from the production improvements that they make. Competition in the marketplace often prompts those producers to apply at least some portion of these cost savings into reducing the asking price for their goods. When this happens, consumers pay less for those goods; and consequently deflation has occurred, since purchasing power has increased.

4. Deflation may be caused by a combination of the supply and demand for goods and the supply and demand for money, specifically the supply of money going down and the supply of goods going up. Historic episodes of deflation have often been associated with the supply of goods going up (due to increased productivity) without an increase in the supply of money, or (as with the Great Depression and possibly Japan in the early 1990s) the demand for goods going down combined with a decrease in the money supply.

Indian scenario – Last few years we saw massive boom in all the sectors. There were huge demands for real estate properties, IT services, Cements, Food products etc. Our economy was growing in excess of 9% and mood was upbeat. Everybody thought this growth will continue forever. Hence, corporate invested heavily in building capacity, developers invested billions of dollars in launching new projects etc. Suddenly the boom busted due to financial crisis. People lost jobs, interest rates went up through the roof and demand plunged. There was a huge mismatch between supply (more) and demand(less). This led to price correction - real estate saw over 40% drop in prices, commodities went down by over 70% and so on. Moreover, due to global financial crisis, there is acute shortage of liquidity in the market and hence less flow of money in the economy. People are holding back to their investments as well as consumption; thus, reducing velocity of money. Does it sound like symptoms of deflation?

Effects of deflation

1. Deflation leads to decrease in prices of good and services, increasing value of money. While an increase in the purchasing power of one's money sounds beneficial, it can actually cause hardship when the majority of one's net worth is held in illiquid assets such as homes, land, and other forms of private property.

2. Deflation raises real wages, which are both difficult and costly for management to lower. Moreover, falling prices and demand discourages corporations from investing. This frequently leads to layoffs and makes employers reluctant to hire new workers, increasing unemployment.

3. Deflation often follows a period of nearly zero interest rates. When the central bank has lowered nominal interest rates all the way to zero, it can no longer further stimulate demand by lowering interest rates. This is the famous liquidity trap. When deflation takes hold, it requires "special arrangements" to "lend" money at a zero nominal rate of interest (which could still be a very high real rate of interest, due to the negative inflation rate) in order to (artificially) increase the money supply.

Why deflation is bad?

While shoppers see falling prices as a good sign, economists see it as a threat to the economy or nation. Deflation hurts the economy much more than inflation. In fact a small positive inflation is good for the economy because it suggests growing demand as well as healthy economy. However, in deflationary conditions consumers postpone expenditure, because they think prices will decrease further. This decreases demand in the economy which badly affects firms, who then scale back production and investment plans, leading to job losses, further affecting purchasing power and demand, which leads to a downward spiral in the economy.

We will now take a look at the most infamous deflation in the history of modern world.

Deflation in Japan

Deflation in Japan started in the early 1990s. The Bank of Japan and the government tried to eliminate it by reducing interest rates, but this was unsuccessful for over a decade. In July 2006, the zero-rate policy was ended. There were several reasons for deflation in Japan which are explained below:

1. Bust of Asset price bubble: There was a rather large price bubble in both equities and real estate in Japan in the 1980s (peaking in late 1989). When assets decrease in value, the money supply shrinks, which is deflationary.

2. Insolvent companies: During the boom time (1980s) Japanese banks lent aggressively to companies and individuals that invested in real estate. However, when real estate values dropped, people were not able to pay back these loans to banks. The banks tried to collect the collateral (land or properties), but this wouldn't pay off the loan because their prices had fallen significantly. Banks delayed their decision to foreclose these loans hoping asset prices would improve. These delays were also allowed by national banking regulators. This continuing process is known as maintaining an "unrealized loss", and until the assets are completely revalued and/or sold off (and the loss realized), it will continue to be a deflationary force in the economy. Improving bankruptcy law, land transfer law, and tax law were suggested by leading economists as methods to speed this process and thus end the deflation.

3. Insolvent banks: Japanese banks had a larger percentage of their loans as "non-performing" i.e. they were not receiving any interest payments on them, but have not yet written them off. With high non-performing loans or assets, they were unable to lend more money; thus, their earnings declined significantly and risk of insolvency increased many a fold.

4. Imported deflation: Japan imports Chinese and other countries' inexpensive consumable goods, raw materials (due to lower wages and fast growth in those countries). Thus, prices of imported products were decreasing with the rise of economy of scale in China. Domestic producers had to lower their prices in order to remain competitive. This decreasing in prices of domestic products over a period of time led to deflation.

5. Fear of insolvent banks: Japanese people were afraid that banks might collapse so they preferred to buy gold or (United States or Japanese) Treasury bonds instead of saving their money in local bank accounts. Thus less money was available for lending and therefore economic growth. This meant that the savings rate depresses consumption, but did not appear in the economy in an efficient form to spur new investment.

Deflation alarms in the US?

With the fed fund rate at a historic low (0.00-0.25%), there is a growing fear of deflation in the US. Many economists believe that USA could face short term period of deflation. With the bust of housing bubble, acute shortage of credit and falling consumption, USA has more or less similar conditions that were prevalent in Japan in early 1990s. However, I believe there are some basic yet crucial differences.

Firstly, Japanese companies were far more dependent on commercial banks for financing than are today's U.S. multinationals, which have stockpiles of internal capital as well as broader access to capital markets. Moreover, US Treasuries are still considered as the safest investments in the world. This keeps the flow of money into the US economy.

Secondly, Bank of Japan’s exceptionally poor monetary policymaking was a big reason for the country's protracted problem. The central bank's failure to lower interest rates in the early 1990s ultimately drove the economy into a deflationary death spiral. They were just too slow and conservative to react to the situation. However, US Fed has been quite aggressive and proactive in taking sound monetary decisions and ensuring that they do not repeat those mistakes. In 1992, for example, amid negligible inflation and a comatose economy, the Bank of Japan's key interest rate was still nearly 4%. In contrast, after the tech bubble burst in the USA, the Fed quickly slashed its benchmark rate to 1 %. Also, the current fed rate is between 0.00-0.25%.

Thirdly, though both USA and Japan faced housing trouble and mortgage crisis, Japan's central bank was too slow to act. The country's banks hid their bad loans beneath opaque corporate structures rather than absorb the losses. But rather than write off the loans, Japanese banks extended additional credit to borrowers, allowing them to at least make minimal interest payments. Those made banks look healthier than they were, at the cost of impairing the flow of credit to new businesses. However, American banks have been forthcoming in absorbing the losses on their books and writing off loans. This has given fed a clear picture of true losses and subprime crisis in the economy.

Having said that I believe the US economy may bleed for some time and enter a period of deflation. However, that period would be short lived and not as prolonged as that of Japanese economy in 1990s. As per an estimate, avoiding a long period of deflation and recession might cost the US a staggering $3 Trillion.

Will India face deflation?

Let’s examine Indian economy vis-à-vis Japanese economy of 1990s. In the last five years BSE exchange went up from 5,000 to 21,000, an increase of 400% while real estate prices in Indian witnessed an increase of over 300%. This is phenomenal increase in prices and asset prices looked highly inflated. After the global financial crisis, Indian stock exchange plunged by over 60% and real estate values dropped by almost 30-40% in less than six months. Some welcomed this fall while majority believed Indian global dream is finally over. The mayhem still continues with stock prices and real estate prices further going down.

Compare this with that of Japan - In the five years before its 1989 peak, the Nikkei (Japanese stock exchange) stock average rose 275%. Property prices became so inflated that the tiny spit of land surrounding the Imperial Palace in central Tokyo was briefly worth more than the entire state of California. At the time, Japan's seemingly unstoppable rise inflamed fears among Americans that the United States had slipped into permanent economic inferiority. When the bubble finally busted in late 1989, stock and property prices nose-dived in tandem. In less than three years, the Nikkei stock average fell 63% from its peak of 38,916. It didn't hit bottom until April 2003 and a total decline of 80%. Do these two stories sound similar? Yeah they do!

Inflation figures for the last week was 3.92% which is far less than the peak rate of 12% less than six months back. Are we going into a period of negative inflation or deflation? We are currently in a state of disinflation which is a decreasing value of inflation as the inflation rate is still positive. However, this may lead to a situation where downward price movement continues and we enter a period of deflation. I believe this is highly unlikely because we are a growing economy with very young population. Moreover, we are not an export oriented economy and hence do not depend too much on external demand. Our economy is mostly driven by domestic demand and consumption, which is somewhat insulated from other countries and global events. We still have lot of room to maneuver our policies to regenerate demand and spending. Yet, with the growing globalization we too run a risk of deflation if our monetary and fiscal policies are not handled well.

How deflation can be avoided?

To counter deflation we have to revitalize our growth story, reignite demand and create confidence among people. Compare to the inflation rate, 3.92%, lending rates in India are still close to 10%, which is quite high. Unless lending rates do not come down people won’t buy properties, automobiles or other consumer goods. Moreover, corporate won’t be able to borrow money to launch new innovative projects, spend on infrastructure or build capacity. Thus, to create demand and investments, government as well as RBI has to bring down this lending rate by implementing ways to reduce cost of borrowing funds.

Hence, only monetary policy won’t be sufficient to tackle this menace; fiscal policy too has to play a significant role here. Government has to be more aggressive in implementing reforms and speeding up infrastructure spending. Let us hope better sense will prevail among our political class.

Rahul Singh www.theindianmoney.com

211) Fixed Income Securities - Bonds Basics

A bond is a debt security, similar to an I.O.U (I Owe yoU) .When you purchase a bond; you are lending money to the issuer which may be a government, municipality, corporation, federal agency, corporate or other entity. In return for the loan, the issuer promises to pay you a specified rate of interest during the life of the bond and to pay back the face value of the bond or the principal when it “matures,” or comes due.

Among the types of bonds you can choose from are: government securities, municipal bonds, corporate bonds, mortgage and asset—backed securities and foreign government bonds.

Types of Bonds

Zero coupon bonds do not pay any interest. They are issued at a substantial discount to par value. The bond holder receives the full principal amount on the redemption date. Zero coupon bonds may be created from fixed rate bonds by a financial institutions separating "stripping off" the coupons from the principal. In other words, the separated coupons and the final principal payment of the bond are allowed to trade independently.

Government Securities is a bond where government is the issuer or borrower. It is the safest form of bond as it is extremely unlikely that the government defaults (unless the economy is as bad as that of Pakistan). Government issues bonds to raise money for funding infrastructure development, support subsidies or several other initiatives. For example government of India has recently started issuing fertilizer and oil bonds to Public Sector companies to fund subsidies on fertilizers and oils.

Municipal Bond is a bond issued by a state, local government, or their agencies. Interest income received by holders of municipal bonds is often exempt from the income tax and from the income tax of the state in which they are issued, although municipal bonds issued for certain purposes may not be tax exempt.

Corporate Bond is a bond issued by corporate i.e. public or private companies to the investors. The company borrows money from investors and promise to pay interest at regular interval. The interest rates on such bonds are high compared to government bonds because the probability of government defaulting on interest payments is low compared to that of corporate. Hence, corporate bonds have high risk and hence require higher return.

High Yield Bonds are those bonds that are rated below investment grade (lower than BBB-) by the credit rating agencies. I will talk in details about rating agencies and bond rating. As these bonds are more risky than investment grade bonds, investors usually expect to earn a higher yield. These bonds are also known as Junk Bonds.

Inflation linked bonds are bonds where the principal amount and interest payments are indexed to inflation. The interest rate is usually lower than that of fixed rate bonds with a comparable maturity. Though, as the principal amount grows, the payments increase with inflation. The government of the United Kingdom was the first to issue inflation linked bonds in the 1980s. Treasury Inflation-Protected Securities (TIPS) and I-bonds are examples of inflation linked bonds issued by the U.S. government.

Other indexed bonds, for example equity-linked notes and bonds indexed on a business indicator (income, added value) or on a country's GDP.

Asset-backed Securities are bonds whose interest and principal payments are backed by underlying cash flows from other assets. Examples of asset-backed securities are mortgage-backed securities (MBS's), collateralized mortgage obligations (CMOs) and  also collateralized debt obligations (CDOs).

Subordinated Bonds are those that have a lower priority than other bonds of the issuer in case of liquidation/winding up. In case of bankruptcy, there is a hierarchy of creditors. First and foremost the liquidator is paid, then government taxes, etc. The first bond holders in line to be paid are those holding what is called senior bonds. After these senior bonds have been paid, the subordinated bond holders are paid. As a result, the risk is higher. Thus, subordinated bonds generally have a lower credit rating than senior bonds. The main examples of subordinated bonds can be found in bonds issued by banks, and asset-backed securities. The latter are often issued in tranches. The senior tranches get paid back first; the subordinated tranches are paid later.

Perpetual Bonds are generally called perpetuities. They have no maturity date.

Bearer Bond is an official certificate issued without a named holder. In other words, the person who has the paper certificate that is the bearer can claim the value of the bond. Usually they are registered by a number to prevent counterfeiting, but may be traded like cash. Bearer bonds are very risk prone because they can be lost or stolen.

Registered Bond is a bond whose ownership and any subsequent purchaser are recorded by the issuer, or by a transfer agent. It is the alternative to a Bearer bond. Interest payments, and the principal upon maturity, are sent to the registered owner only.

Fixed Rate Bonds have a coupon (interest) that remains constant throughout the life of the bond.

Floating rate notes (FRNs) have a coupon which is linked to an index. Common indices include: money market indices, such as LIBOR or Euribor, and CPI (the Consumer Price Index). Coupon examples: 3 month USD LIBOR + 0.20%, or twelve month CPI + 1.50%. FRN coupons reset periodically, usually every one or three months. In assumption, any Index could be used as the basis for the coupon of an FRN, so long as the issuer and the buyer can agree to terms.

Features of Bonds

The most important features of a bond are:

Principal or face amount -It is the amount on which the issuer pays interest, and which has to be repaid at the end.

Issue price - It is the price at which investors buy the bonds when they are first issued, which will normally be approximately equal to the principal amount. The net proceeds that the issuer receives are thus the issue price, less issuance fees.

Maturity date -It is the date on which the issuer has to repay the principal amount. As long as all payments have been made, the issuer has no more compulsions to the bond holders after the maturity date. The length of time until the maturity date is called as the term or tenure or maturity of a bond. The maturity can be any length of time, though debt securities with a term of less than one year are generally designated money market instruments rather than bonds. Most bonds have a term of up to 30 years. Few bonds have been issued with maturities of up to one hundred years, and some even do not mature at all. In early 2005, a market developed in Euros for bonds with a maturity of fifty years.

In the market for government securities, there are three groups of bond maturities: 

• Short term (bills): maturities up to 1 year;

• Medium term (notes): maturities between 1 and 10 years;

• Long term (bonds): maturities greater than 10 years.

Coupon -Coupon is the interest payment that the issuer pays to the bond holders. Generally coupon rate is fixed throughout the life of the bond. It can also vary with a money market index, like LIBOR, or it can be even more exotic. The name coupon originates from the fact that in the past, physical bonds were issued which had coupons attached to them. On coupon dates the bond holder would give the coupon to a bank in exchange for the interest payment.

Indentures and Covenants - An indenture is a formal debt agreement that creates the terms of a bond issue, while covenants are the clauses of such an agreement. Covenants state the rights of bondholders and the duties of issuers, such as actions that the issuer is obligated to perform or is prohibited from performing. In the central and state securities and commercial laws apply to the enforcement of these agreements, which are interpreted by courts as contracts between issuers and bondholders. The terms may be changed only with great difficulty while the bonds are outstanding, with amendments to the governing document usually requiring approval by a majority (or super-majority) vote of the bondholders.

Coupon date- These are the dates on which the issuer pays the coupon to the bond holders. In the India most bonds are semi-annual, which means that they pay a coupon every six months.

We will now discuss Government bonds in great detail in rest of the article.

Government Bond

A Government security is a tradable security issued by the Central Government or the State Governments, acknowledging the Government’s debt obligation. Such securities can be short term (usually called Treasury Bills, with original maturities of less than 1 year) or long term (usually called Government bonds or dated securities with original maturity of one year or more). In India, the Central Government issues both Treasury Bills and bonds or dated securities while the State Governments issue only bonds or dated securities, which are called the State Development Loans (SDLs). Government securities carry practically no risk of default and, hence, are called risk-free instruments. Government of India also issue savings instruments (Savings Bonds, National Saving Certificates (NSCs), etc.) or special securities (Oil bonds, FCI bonds, fertilizer bonds, power bonds, etc.) but they are usually not fully tradable and are not eligible for meeting the SLR requirement.

One of the world’s largest and most liquid bond markets is comprised of debt securities issued by the U.S. Treasury, by U.S. government agencies and by U.S government-sponsored enterprises.

Treasury Bills (T-Bills)

Treasury Bills, which are money market instruments, are short term debt instruments issued by the Government of India and are presently issued in three tenors, viz., 91 day, 182 day and 364 day. Treasury Bills are zero coupon securities and pay no coupon. They are issued at a discount and redeemed at the face value at maturity. The return to the investors is, therefore, the difference between the maturity value or face value (i.e., Rs.100) and the issue price.

For example, a 91 day Treasury Bill of Rs.100/- (face value) may be issued at a discount of say, Rs.1.80, that is Rs.98.20 and redeemed at the face value of Rs.100. Thus, the buyer will pay Rs. 98.2 today for 1 unit of Treasury Bill worth Rs. 100. After 91 days he will get Rs. 100. Hence, his return would be:

(100-98.2)/98.2 = 1.83% for 91 days period

  = 1.83*4 for 1 year (Simple Interest payment i.e. 365/91 ~ 4 periods)

  = 7.32% per annum simple interest rate.

Treasury Bills are issued through auctions conducted by the Reserve Bank of India usually every Wednesday and payments for the Treasury Bills purchased have to be made on the following Friday. The Treasury Bills of 182 days and 364 days' tenure are issued on alternate Wednesdays, that is, Treasury Bills of 364 day tenure are issued on the Wednesday preceding the reporting Friday while Treasury Bills of 182 days tenure are issued on the Wednesday prior to a non-reporting Friday. Currently, the notified amount for issuance of 91 day and 182 day Treasury Bills is Rs.500 crore each whereas the notified amount for issuance of 364 day Bill is higher at Rs.1000 crore.

An annual calendar of T-Bill issuances for the following financial year is released by the Reserve Bank of India in the last week of March. The Reserve Bank of India also announces the issue details of Treasury bills by way of press release every week.

Dated Government Securities

Dated Government securities are longer term securities and carry a fixed or floating coupon (interest rate) paid on the face value, payable at fixed time periods (usually half-yearly). The tenor of dated securities can be up to 30 years. The Public Debt Office (PDO) of the RBI acts as the registry / depository of

Government securities and deals with the issue, interest payment and repayment of principal at maturity. Most of the dated securities are fixed coupon securities. The nomenclature of a typical dated fixed coupon Government security has the following features - coupon, name of the issuer, maturity and face value. For example, 7.49% GOI 2017 would have the following features:

Date of Issue    : April 16, 2007

Date of Maturity   : April 16, 2017

Coupon     : 7.49% paid on face value

Coupon Payment Dates   : Half-yearly (October16 and April 16) every year

Minimum Amount of issue/ sale  : Rs.10,000

Dated securities may be of the following types:

1. Fixed Rate Bonds

2. Floating Rate Bonds

3. Zero Coupon Bonds

4. Capital Indexed Bond

5. Bonds with Call/Put Options

State Development Loans (SDLs)

State Governments also raise loans from the market. SDLs are dated securities issued through an auction similar to the auctions conducted for dated securities issued by the Central Government. Interest is serviced at half-yearly intervals and the principal is repaid on the maturity date. Like dated securities issued by the Central Government, SDLs issued by the State Governments qualify for SLR. They are also eligible as collaterals for borrowing through market repo as well as borrowing by eligible entities from the RBI under the Liquidity Adjustment Facility (LAF).

How are the Government Securities issued?

Government securities are issued through auctions conducted by the RBI. Auctions are conducted on the electronic platform called the Public Debt Office – Negotiated Dealing System (PDO-NDS). Commercial banks, scheduled urban cooperative banks, Primary Dealers, insurance companies and provident funds, who maintain funds account (current account) and securities accounts (SGL account) with RBI, are members of this electronic platform. All members of PDO-NDS can place their bids in the auction through this electronic platform. All non-NDS members including non-scheduled urban co-operative banks can participate in the primary auction through scheduled commercial banks or Primary Dealers. For this purpose, the urban co-operative banks need to open a securities account with a bank / Primary Dealer – such an account is called a Gilt Account. A Gilt Account is a dematerialized account maintained by a scheduled commercial bank or Primary Dealer for its constituent (e.g., a non-scheduled urban co-operative bank).

The RBI, in consultation with the Government of India, issues an indicative half-yearly auction calendar which contains information about the amount of borrowing, the tenor of security and the likely period during which auctions will be held. A Notification and a Press Communiqué giving exact particulars of the securities, viz., name, amount, type of issue and procedure of auction are issued by the Government of India about a week prior to the actual date of auction.

Types of Auction

With the introduction of auctions, the rate of interest (coupon rate) gets fixed through a market based price discovery process. An auction may either be yield based or price based.

Yield Based Auction

A yield based auction is generally conducted when a new Government security is issued. Investors bid in yield terms up to two decimal places (for example, 7.85 per cent, 7.87 per cent, etc.). Bids are arranged in ascending order and the cut-off yield is arrived at the yield corresponding to the notified amount of the auction. The cut-off yield is taken as the coupon rate for the security. Successful bidders are those who have bid at or below the cut-off yield. Bids which are higher than the cut-off yield are rejected. An illustrative example of the yield based auction is given below:

Yield based auction of a new security

• Maturity Date: September 8, 2018

• Coupon: It is determined in the auction (8.22% as shown in the illustration below)

• Auction date: September 5, 2008

• Auction settlement date: September 8, 2008

• Notified Amount: Rs.1000 crore

The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment pro-rata so that the notified amount is not exceeded. In the above case each would get Rs. 50 Crore. Bid numbers 7 and 8 are rejected as the yields are higher than the cut-off yield.

Price Based Auction
A price based auction is conducted when Government of India re-issues securities already issued earlier. Bidders quote in terms of price per Rs.100 of face value of the security (e.g., Rs.101.02, Rs.100.95, Rs.99.80, etc., per Rs.100/-). Bids are arranged in descending order and the successful bidders are those who have bid at or above the cut-off price. Bids which are below the cut-off price are rejected. An illustrative example of price based auction is given below:

Price based auction of an existing security 8.24% GS 2018
• Maturity Date: April 22, 2018
• Coupon: 8.24%
• Auction date: September 5, 2008
• Auction settlement date: September 8, 2008
• Notified Amount: Rs.1000 Crore 

The issuer would get the notified amount by accepting bids up to 5. Since the bid number 6 also is at the same yield, bid numbers 5 and 6 would get allotment in proportion so that the notified amount is not exceeded. In the above case each would get Rs. 50 Crore. Bid numbers 7 and 8 are rejected as the price quoted is less than the cut-off price.

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210) Inflation and RBI’s response to it in 2008

You may remember that the main culprits of inflation last year were:
1. Higher crude prices – Due to rapid growth of global economy in 2007 and early 2008 there was a huge demand for crude. Also, when stock market started showing weaknesses across the globe, investors started parking their money in commodities such as Crude.
2. Supply constraint – Unprecedented drought in Australia and some part of Americas caused shortage of food grains in the global market. India too had a very bad production year and we had to import grains from the global market. This led to increase in general increase in food grains prices.
3. Excess liquidity – High growth in emerging economies like India attracted huge amount of foreign capital. A situation like too much money chasing too few goods lead to inflation. This exactly what happened in India.

Why does rise in crude price lead to inflation?
Let us begin with a brief discussion on crude prices. It is an extremely important commodity which affects our day to day life in some form or other. Crude prices gave sleepless nights to almost everyone on this planet. It touched $140 per barrel within no time. Government across the world was busy thinking about how to tame inflation which resulted from crude prices. This indicates that the crude price directly affects the inflation. I have done a comparative analysis of increase in crude price and inflation to figure this out.

You can see the graphs for crude oil prices and inflation rate almost mirrors itself. Would it be safe to assume that crude influences inflation to a great extent? Well to a great extent YES. The crude price is an extremely important part of inflation calculation whether it is based on CPI or WPI. If we see the table below, fuel has over 10% weight in the WPI index, which is used to calculate inflation in India. Moreover, the change of fuel prices affects almost every goods and services in India because it increases transportation costs, cost of production for manufacturing and utilities prices. Thus, any change in fuel price affects inflation.

for more pls click the below mentioned link.

http://theindianmoney.com/article-display.php?cat_id=1⊂_id=113&aid=145&acat=&ahead=Inflation%20and%20RBI’s%20response%20to%20it%20in%202008

209) High forex reserves can worsen recession

High foreign exchange reserves have, in the current global recession, saved Asian countries (including India) from the travails they suffered in the Asian financial crisis of 1997-2000. So, they must aim for rising forex reserves in future too, right? Wrong. 

In truth, high Asian forex reserves are an important reason for the current recession. High reserves promise safety in a storm. But, beyond a point this safety becomes illusory, because rising forex reserves worsen the global imbalances that have precipitated the recession. 

The global recession has many roots. One is the erosion of traditional US household prudence. US households used to save 6% of their disposableincome. But in recent years they went on a borrowing and spending spree, and household savings dropped to virtually zero. Corporations and financiers also ran up record debts, partly to buy assets such as houses, stocks and commodities. This created huge bubbles in all three markets. 

When the bubbles finally burst, US households, corporations and financiers found themselves in dire straits. Many financial giants were rescued by the government. Meanwhile households, sobered by the turn of events, started saving 4% of disposable income, up from zero. More saving meant less spending, and made the recession deep and sharp. 

Most Asians are smugly blaming US imprudence and loose financial regulation for the crisis, while portraying themselves as innocent victims. Yet, they must share the guilt too. US profligacy did not arise in a vacuum. It arose in part because Asian insistence on high forex reserves meant that they poured dollars into the US to buy US securities. This flood of dollars from Asia drove down US interest rates, making it very attractive to borrow. That spurred the borrowing spree, and the accompanying bubbles. 

Historically, rich countries had surplus savings, manifested in a trade surplus. Poor countries lacked savings, manifested in trade deficits, with the deficit being plugged by an inflow of dollars from rich to poor countries. For the world as a whole, current account surpluses and deficits of countries must necessarily balance. Historically, the surpluses of rich countries were offset by the deficits of poor ones. 

But after the Asian financial crisis, something strange happened. Asian countries, above all China, began generating huge savings surpluses, manifested in huge current account surpluses. Many used undervalued exchange rates to artificially create trade surpluses, which were then invested in US treasuries (that is what foreign exchange reserves are). 

However, poor Asians could not run huge surpluses unless others were willing to run huge deficits. Remarkably, the rich US began to do so. This arose partly from the sophistication of its financial system, which found many ways - too many, in fact - of converting the flood of money from Asia into a borrowing and spending spree. This sharp rise in US spending boosted the global economy, and created the record global GDP growth in 2003-08. US demand sucked in huge quantities of manufactures and services from Asia, above all from China. Asian manufacturing sucked in huge quantities of commodities from Africa and Latin America, raising incomes there too. 

Alas, this boom was based on huge global imbalances that had to be corrected at some point. No country, not even the rich US, could keep running gargantuan trade deficits forever, to offset the surpluses of Asia. US asset bubbles burst, the boom ended, and US spending and imports plummeted. 

Ending the consequent recession means reducing global imbalances to manageable proportions. Americans will have to save more, spend less and export more. Asian countries, especially China, will have to consume more, save less, and export less. This re-balancing will restore global balance, and enable global growth to rise sustainably again. 

However, such re-balancing means that Asian countries must stop piling up ever-rising forex reserves (and trade surpluses). Such reserves represent excessive saving, excessive exports and insufficient imports. Excess forex reserves have provided apparent safety to Asian countries in a recessionary crisis, yet are also a cause of that very crisis. 

What will happen if Asians insist on trying to keep savings and forex reserves high? Well, if Asians keep savings high and Americans and Europeans do so too, then world demand will collapse and the recession will become a Depression. Asians must recognise that high forex reserves serve as a safety cushion only up to a point, and beyond that exacerbate global imbalances that threaten disaster. Saving too much can be as harmful as saving too little. Unless Asian countries recognize this and go slow on future reserve accumulation, the recession may become worse than anyone dares imagine today.

208) BASEL II roadmap

The Reserve Bank of India (RBI) has worked out the roadmap for the Indian banks to graduate from the simpler approaches of the Basel II framework to more advanced ones.

Basel II is the second among Basel Accords, which are primarily, recommendations on banking laws and regulations issued by the Basel committee on banking supervision.

It sets up rigorous risk and capital management requirements aimed at ensuring that a bank holds capital reserves appropriate to the risk it exposes itself to through its lending and investment practices.

Since March 2008, foreign banks operating in India and Indian banks having presence outside the country have migrated to simpler approaches under Basel II framework. Other commercial banks are required to migrate to these norms by March 31, 2009.

These include standardised approach for credit risk which arising from default by borrowers, basic indicator approach for operational risk (arising from day to operations of the banks such robbery or power failure) and standardised duration approach for market risk (arising from fluctuations in interest rate and share prices) which affects the investment and market portfolio of the banks.

In the framework, the RBI had earlier specified the date by which banks may file application for approvals and the the likely date by which approvals can be obtained from the central bank.

While banks have the discretion to adopt the advanced approaches, they need to seek prior approval.

Under market risk, banks may apply to RBI for graduating to more advanced method of internal models approach (IMA) by April 1, 2010 and then, RBI may approve it by March 31, 2011. IMA sets out a framework for applying capital charges to the market risks (both on balance sheet and off-balance sheet) incurred by banks by an internal model. The current standardised duration approach specifies a specific average duration of the banks at large, which the banks follow and make it a basis for applying capital charges to only open positions.

Similarly, for operational risk, banks may graduate to standardised approach by April 1, 2010 and RBI can approve the plan by September 30, 2010. After that, they can graduate to advanced measurement approach for operational risk by April 1, 2011 and get RBI approval by March 31, 2013.

While advanced measurement approach (AMA) sets the framework for banks to develop their own empirical model to quantify required capital for operational risk, it can be used after they get regulatory clearances.

Under the standardised approach, a bank's activities are divided into eight business lines: corporate finance, trading and sales, retail banking, commercial banking , payment and settlement, agency services, asset management and retail brokerage. Within each business line, gross income is a broad indicator for the scale of business operations and so, the scale of operational risk exposure within each of these business lines. The capital charge for each business line is calculated by multiplying gross income by a factor .

Currently, banks are using the basic indicator approach as per which they must hold capital for operational risk equal to the average over the previous three years of a fixed percentage of positive annual gross income.

For credit risk, banks can use internal ratings-based approach which allows them to develop their own model to estimate the probability of default for individual clients or groups of clients. Currently, banks use standardised approach where they are required to use ratings from external credit rating agencies to quantify the required capital for credit risk.