Sharp rise in State Govts’ borrowing costs

The State Governments’ borrowing costs have seen a sharp escalation despite the liquidity overhang in the financial markets.
The sharp increase in costs was evident from the last auctions for the State development loans held on August 25. The loans were placed at an average yield of 8.22 per cent or a little over 100 basis points over the sovereign ten-year yield bonds. State development loans are normally placed for tenures of 10 years. The spreads have progressively increased since the beginning of this financial year. At the April auctions, the spreads were barely 75 basis points.
Increase in demand
The Chief Economist of rating agency Credit Analysis & Research Ltd, Dr Soumendra K. Dash, said, “The hardening is partly on account of an increase in the State Governments’ liquidity demands this year.” The liquidity demand, in turn, has pushed the State Governments to increase the frequency of their market entry, he added. States have raised close to Rs 4,900 crore through SDLs since the beginning of this financial year.
Traders said that the firming of yields was also on account of market aversion to long dated securities, partly on account of the high incremental investment deposit ratios (IDR) of the banks. Incremental IDR this year so far is about 87 per cent. The nominal ratio is about 33 per cent, well over the prescribed Statutory Liquidity Ratio of 24 per cent.
Short dated securities
Besides, banks which are the largest investors in Government securities have shifted their preference to short dated securities largely on account of the rising liquidity concerns in the markets. The liquidity concerns stemmed from fears that the Government was likely to push for an increase in farm credit in view of the severe drought that has hit large parts of the country.
In addition, bank officials said that the preference for shorter dated securities were also on account of depreciation concerns. Almost all banks have at least 25 per cent of their demand and time liabilities in the Held to Maturity (HTM) category. Consequently, all the incremental holdings are in the marked to market category – Available for sale or in the Held for Trading category.
Bank officials said that most of them picked up the SDLs under the Held for Trading category, with the idea of selling the same to the Life Insurance Corporation of India and other life insurers. Under the existing regulations, banks are permitted to hold securities in the HFT portfolios only up to a maximum of 90 days.
Switch operations
The officials also said that the increase in the yields, were therefore partly on account of the Life Insurance Corporation’s purchases from the banks, through switch operations. Switch operations involve exchange of securities. LIC and other large life insurance companies constantly switch their respective short dated securities for long dated ones. This was in view of the longer tenure liabilities that LIC has in its policy holders’ funds. However, in the switch operations, LIC tended to drive hard bargains, pricing its purchases at high yields and at the same selling its shorter dated securities at lower yields.