After scorching credit growth in the last two years, banks are bracing themselves to fight it out on the deposit front by jacking up interest rates.
This is set to intensify as banks are left with little leeway to generate resources, since most of them have hit the minimum level of regulatory investments in government bonds, known as statutory liquidity ratio.
Banks are required to invest 25 per cent of their net demand and time liabilities (deposits) in government bonds, which qualify for SLR. Two years ago, in March 2004, the banking system's SLR holding was close to 42 per cent.
With credit picking up fast, most banks have liquidated their excess SLR holdings to support the credit growth and, in the process, hit the minimum requirement level of 25 per cent.
This means they cannot scale down their investment portfolio any more to generate liquidity. As a result of this, banks need to buy bonds from the market to maintain the SLR level and also aggressively mop up deposits to support the credit growth.
According to banking sources, except for a few banks like State Bank of India, Punjab National Bank and Indian Bank, most have scaled down their SLR level to around 25 per cent.
"The average SLR holding of the banking system could be a little over 26 per cent but this does not give the correct picture, as some of them have scaled it down to just about 25 per cent," said a bond dealer.
A few are using the Reserve Bank of India's reverse repo window to maintain their SLR level on every reporting Friday.
This essentially means these banks are borrowing government bonds from the central bank to maintain the minimum investment level they require to report on alternate Fridays. In March, the SLR level was 31.3 per cent.
The RBI infuses liquidity in the system through its repo window and sucks out excess liquidity through its reverse repo window. Banks are required to offer SLR bonds as collateral to avail of the liquidity facility. Conversely, the RBI offers bonds when it takes money from the banks.
The investment portfolios of banks contracted by 3.1 per cent in 2005-06, after a slower 7.4 per cent growth in 2004-04. The investment books of banks had increased by 23.9 per cent in 2003-04.
An increase of over 20 per cent in investments was normal for banks.
Banks are intensely engaged in expanding their deposits kitty with the SLR leeway no longer available to fund credit demand. In the process, they are increasing the demand for government bonds as well as the rates of deposits.
Most banks are now offering over 8 per cent interest on long-term deposits. "As the banks grow their deposit base, they need to buy more and more government bonds to meet the 25 per cent SLR requirement," said a banker.
A note by CLSA Asia-Pacific Markets says at the current pace of deposit accretion (over 21 per cent), the excess SLR cushion at the banking industry level will be exhausted in the next six months.
Assuming a 15 per cent growth in deposits in 2007-08, it estimates that the banking system will need to invest over Rs 1,00,000 crore (Rs 1,000 billion) in government bonds, virtually equivalent to the entire annual net borrowing of the government.
The demand for government bonds has seen yields on government bonds dropping. The yield on the benchmark 10-year bond is 80 basis points down to 7.6 per cent from a high of 8.4 per cent in July 2006.
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