Easing liquidity in the bond market and the hopes of more rate cuts from the RBI have driven the rally. The bond market went into a big rally on Budget day with yields falling sharply. The reason was a positive surprise. Nobody expected the Fiscal Deficit to be held to 3.5% of GDP. The Government’s borrowing programme in 2016-17 will be somewhat less than in 2015-16.
Read our full coverage on Union Budget 2016
There are also hopes that the RBI will cut rates in early April, at its next bi-monthly policy review. Some optimists are hoping for an earlier rate cut – after all, the RBI made an out-of-turn rate cut in 2015. I am not so sure the RBI will cut rates, either out-of-turn or in April. Retail inflation in January was running at 5.69% year-on-year. Given projections in a range of 4.5% to 5.5% this fiscal (according to the Budget 2016 Highlight) and a target of 5% by January 2017 ( according to RBI), there is not much room for instant rate cuts.
The market is betting on the short-term. Even if NPAs remain uncovered, and net worth is dangerously low on some PSB balance sheets, that is a long-term problem. In the short-term, there is better liquidity.
The Budget did disappoint in one important respect. The recapitalisation allocation of Rs 25,000 crore is much lower than required to put public sector banks (PSBs) back on a sound footing. Close to ten times that amount may eventually be required.
PSBs may come under even more stress this year given that they will have to lend more under the expanded agricultural lending programme of Rs 9 lakh crore. However, there is a possibility that some “sticky assets” in stalled infrastructure projects will become recoverable.
There are other positives. One is that the bond market rally has led to capital gains in the portfolios of banks holding treasuries. Second, the RBI has changed capital adequacy rules to allow banks to count the value of their land holdings (at 55% of current value, after revaluation) as part of Tier-1 Capital. In addition, “forex translation reserves” and deferred tax assets can be counted as Tier-1, subject to discounts. Forex translation reserves arise from translation of overseas operations into rupees. This easing of rules could ramp up PSB tier-1 capital by Rs 35,000 crore or more.
Tier-1 capital is owned funds consisting of equity and reserves. Lending is limited by the Tier-1 quantum. India is committed to meet Basel-III international banking norms which demand higher Tier-1 Capital in time bound fashion. Allowing land, forex translation, deferred tax assets, etc., to count as Tier-1 takes some pressure off the government of India, which has to shore up its equity holdings in PSBs. It also allows PSBs to expand credit.
But this doesn’t compensate banks for losses on bad loans. That money still has to be provisioned and it remains a potential time-bomb. We don’t know if this will explode at all.
The Nifty Bank is less affected by PSB woes because private sector banks have much higher weights in the index and private banks don’t have such problems. But if there’s a problem in a big PSB, it will affect the entire sector. But as of now, traders continue to ride the uptrend.