Is the Indian 10 year G-Sec headed for 10% yield?

I had written in January 2011 about why I felt there is a chance that Rupee headed to 50 against the USD. Today its around 49.5 to the USD. Though we are still to reach 50,I think we can fairly say that at least the thinking process was alright. But given the situation that has come up right I want to shift the goal post a little and see what effects it can possibly have on the government bond market. I am no bond expert but its just a calculated attempt.

I will touch slightly upon the rupee and then take its probable effects on the liquidity and inflation in India to justify my position on the G-sec market.

The situation in Europe is getting worse by the day. Banks are increasingly reluctant to even lend to each other. A corporate like Siemens has parked almost all its liquidity, amounting to roughly 6 bn Euros with the European Central Bank. Credit is getting tighter. US too is not going great. Banks across the globe are scampering to save as much as they in case of sovereign default at Greece and its contagion effects.

India's external debt is around 306 bn USD as of March 2011. I dont have the latest figures but will go ahead with the assumption that it will not have changed dramatically. The Indian forex balance is maintained by the inflow of money in the capital account, given that we are running a current account deficit.

Given the global scenario, it is very likely that inflows in the capital account, both debt and equity, might face a slowdown. In the worst case, a reverse flow may also take place for some period of time.

Given that banks are the ones which are going to be hit the most and our IT companies depend on them in a big way for their businesses, its also possible that IT companies themselves might suffer sales slowdown. That would not help the current account deficit problems.

Of the 306 bn USD for external debt, roughly 84 bn is to be paid within the next 12 months. So there is a need to get this refinanced. But if the banks in Europe and US are struggling, it will not be surprising to less than 100% getting refinanced.

The way rupee has moved from 45 to 49.5 in practically no time means that large FIIs investments are down 10% in USD terms and they havent had a chance to sell. This move has come about without any big scale sale by the FIIs. But if the situation continues, they FIIs will also have to liquidate some of their positions and that only adds to the pressure to rupee.

Current account deficit along with a slowdown in forex inflow will be a deadly combination for the INR to fight. I suspect if that happens, INR will depreciate even further. Maybe 55. Maybe 60.

Can RBI intervene to stabilise the currency? It can. But there is a price to it. It will have to suck out liquidity from the Indian banking system. That will be a blow to the system which in any case is in a liquidity deficit.Daily turnover in the forex markets is more than 8 bn USD on an average. So the intervention required to sustain INR will be reasonable. Thus there is also a limit on how much RBI can intervene.

Then what happens in case, the situation pans out this way.

With rupee depreciating that much, all commodities which are priced on import price parity basis will see their prices going up, unless the prices globally also go down to the same extent as the rupee depreciates.It is very likely that the depreciating rupee will have a inflationary impact.

Plus if the fore debt inflow is slowing down and refinancing is difficult, it might lead to more demand for domestic bank funding. That puts additional pressure on the liquidity situation in the Indian banking system.Banks may withdraw from their excess SLR commitments and lend it.

Inflationary impact of the rupee and bank squeezing their SLRs will have their impact on the yield. RBI intervention in the forex market will only add to the liquidity crunch and take the yields on all loans higher.

This scenario may not play out. Globally commodities, particularly crude oil may fall much faster than the pace of rupee depreciation (which is what happened in 2008). That eases pressure on the trade deficit front, but a global collapse of sorts will also make the FIIs press the sell button and will also reduce exports. Its difficult to quantify, which parameter will be dominant. But nonetheless there is always a chance that the rupee depreciation, if it happens, MAY NOT have the inflationary impact.

The other interesting thing that, there is almost a universal consensus that inflation and thus interest rates in India have peaked out. As I have discussed above, it MAY NOT be so. With the universal consensus being on the side of lower inflation, as of now it is surprising that government bond markets are yet to decisively move yield downwards. But things can change fast. the world is too dynamic.

I am not sure, how all this is ultimately going to play out but i think its worth to keep the above scenario as a part of the thinking process, so that it is not a surprise if we see G-Sec at 10% sometime in the near future. 10% is just an indication of the direction of the yield and not necessarily a target.

FM Pranab Mukherjee recently said its important for global leaders not to lose their nerves in these trying times. It applies to India equally if not more.