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click here to return to main page of Mid-term Review of Annual Policy for the year 2004-05
Mid-term Review of Annual Policy 2004-05- 26th Oct 2004
I. Mid-term Review of Macroeconomic and Monetary Developments in 2004-05
Domestic Developments
21. In recent years, scheduled commercial banks' investment in government and other approved securities has been much in excess of the required statutory liquidity ratio (SLR) of 25 per cent. As at end-March 2004, such excess SLR securities at Rs.2,67,328 crore constituted 16.3 per cent of net demand and time liabilities (NDTL) of banks. However, during the current year, scheduled commercial banks’ investment in government and other approved securities at Rs.27,435 crore (up to October 1, 2004) was lower than that of Rs.76,705 crore in the corresponding period of the previous year partly on account of pick-up in credit demand. Consequently, commercial banks’ excess holding of SLR securities was reduced to Rs.2,61,299 crore or 14.7 per cent of NDTL. Notwithstanding this reduction, the effective SLR investment at 39.7 per cent of NDTL for the banking system as a whole, continues to be high relative to the statutory minimum of 25 per cent. As credit demand is expected to remain buoyant this year, lower appetite for SLR securities has implications for government borrowings in an environment of market determined interest rates.
22. As indicated in the annual policy Statement, the market stabilisation scheme (MSS) was introduced to absorb liquidity of a more enduring nature by way of sterilisation through issuances of Treasury Bills/dated government securities. During 2004-05, liquidity absorption through MSS was Rs.54,146 crore up to October 21, 2004. With the issuance of MSS, the repo volumes tendered under liquidity adjustment facility (LAF) declined from an average of Rs.70,523 crore in April to Rs.13,805 crore in October 2004 (up to October 21). The liquidity that remained sterilised declined from an average of about Rs.81,260 crore in April to Rs.67,321 crore in October (up to October 21). In addition to MSS and repo, surplus balances in the Central Government account with the Reserve Bank also helped in sterilising excess liquidity from time to time. Notwithstanding some decline in surplus liquidity during the year, the overhang of liquidity continues to remain substantial.
23. During 2004-05 (April to October 21, 2004), financial markets have remained generally stable though interest rates have displayed some upward movement, particularly at the longer end. First, the average call money rate increased from 4.29 per cent to 4.57 per cent. Second, the 91-day and the 364-day Treasury Bill rates moved up from 4.42 per cent and 4.45 per cent to 5.20 per cent and 5.49 per cent, respectively. Third, the yield on government securities with 1-year residual maturity increased from 4.51 per cent to 5.51 per cent. Fourth, the yield on government securities with 10-year and 20-year residual maturities increased from 5.14 per cent and 5.76 per cent to 6.72 per cent and 7.16 per cent, respectively. As a result, the spread between 10-year and 1-year government securities moved up from 63 basis points to 121 basis points. Similarly, the spread between 20-year and 1-year government securities increased from 125 basis points to 165 basis points.
24. The weighted average discount rate on commercial paper (CP) of 61 to 90-day maturity increased from 5.08 per cent in April to 5.12 per cent by mid-October 2004. The market repo rate increased from 3.70 per cent to 4.52 per cent with an increase in daily volume from Rs.5,065 crore (one leg) to Rs. 5,587 crore. The average daily volume of CBLO (collateralised borrowing and lending obligation) increased significantly from Rs.2,500 crore to Rs.8,736 crore with an increase in CBLO rate from 3.8 per cent to 4.51 per cent. The typical interest rate on 3-month certificates of deposit (CD) increased from 4.45 per cent in April to 5.25 per cent by October 2004. However, public sector banks reduced their rates for deposits of over 1-year from a range of 5.0-6.0 per cent to 4.75-5.75 per cent.
25. As indicated in the annual policy Statement, commercial banks have announced their benchmark prime lending rates (BPLRs) as advised by the Indian Banks' Association (IBA). The new system of BPLR imparts greater transparency in determination of lending rates while giving complete flexibility to banks to price their loan products either on fixed or floating basis. The BPLRs of public sector and foreign banks remained unchanged in the range of 10.25-11.50 per cent and 11.00-14.85 per cent, respectively, during April-September 2004. The BPLRs for private sector banks, however, moved from a range of 10.50-13.00 per cent in April to a range of 9.75-13.00 per cent by September 2004. The representative (median) lending rates on demand and term loans (at which maximum business is contracted) of public sector banks were in the range of 10.50-12.75 per cent in June as against 11.0-12.75 per cent in March 2004.
26. The risk premium on private sector bonds, as measured by the yield spread between highly rated corporate paper and government securities, has reduced. For example, the spread between AAA-rated corporate bonds of 5 years and the yield on government securities of similar maturity declined from about 80 basis points in April to about 50 basis points by October 2004.
27. The Reserve Bank has been persistently drawing attention of banks to interest rate risks. Accordingly, banks were advised in January 2002 to build-up investment fluctuation reserve (IFR) to a minimum of 5.0 per cent of their investment portfolio. As at end-March 2004, banks had built up IFR up to 3.0 per cent. With the recent trend in interest rates, some of the risks have crystallised. However, there has been some cushion for banks given the conservative accounting norms which do not permit banks to recognise unrealised gains in their portfolio, while requiring them to provide for any known depreciation in their value. Against this background and pending a review of existing guidelines on banks’ investment portfolio, RBI allowed banks to exceed the ceiling of 25 per cent of investments included under HTM category by shifting some of their investments in SLR securities from the HFT/AFS categories to HTM category at the lowest of the acquisition cost or prevailing market value or book value, subject to a maximum of 25 per cent SLR securities to be held in HTM. Consistent with international standards that do not place any cap on HTM category, such a move was considered advisable taking into account the statutory nature of the 25 per cent SLR while ensuring prudence and transparency in valuation on transfer to HTM. While the earlier prescription was relatively more conservative, the recent changes recognised the dynamic interface with the interest rate cycles. While RBI recognises the need for continuing to build up IFR, banks were advised to prepare themselves to implement the capital charge for market risk as envisaged under Basel II norms in a phased manner by end-March 2006.
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