Bonds gained during the week as risk aversion across the financial sector mounted with

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worsening of the crisis in the euro zone.

Banks remained buyers of government securities driving up bond prices or driving down yields. The price of the ten-year benchmark security 7.8 per cent coupon falling due in 2021 rose to Rs 96.74 (par value Rs 100) or a yield of 8.3, up from the previous week’s Rs 96.47 (8.34 per cent).

Bajaj Allianz Life Insurance chief investment officer Sashi Krishnan said, “Risk aversion is an issue. Bonds will, therefore, remain in favour, in this environment.” The soft yields were despite the mounting liquidity deficit in the banking system. At the weekend liquidity adjustment facility auctions, banks borrowing from the Reserve Bank of India amounted to Rs 74,645 crore, though advance tax payments by corporate India for the second quarter almost concluded.

Besides, there were also no government borrowings last week. This year so far the government had borrowed Rs 2.5 lakh crore of the Rs 4.17 lakh crore budgeted for the financial year 2011-12. And markets waited for announcement of the government’s borrowing calendar for the second half of this financial year.

Yet at the collateralised borrowing and lending obligations market, inter-bank lending rates stayed above the RBI’s new repurchase rate (RBI overnight liquidity support to banks) of 8.25 per cent.

The sliding bond yields ensured that cheap government borrowing. Banks holding of government securities is presently 31 per cent. Under presently guidelines banks are expected to hold only 24 per cent of their deposits

in government securities. e Most banks faced with low e credit offtake have been taking to r buying into government securi ties. Incremental credit as a comb ponent of deposits was just 40 per cent according to data released by RBI. Bankers said a large component of the credit increase was partly on account of refinanc ing and working capital offtake from the public sector oil compa nies. Besides, some power project companies, dependent on im ported coal draw down also increased. This was due to in creased prices and depreciation in exchange rate. Last week alone, the rupee has depreciated by 4.2 per cent.

The ability to intervene in the foreign exchange markets is limit ed. Interventions in the foreign exchange markets for support of rupee tend to squeeze liquidity.

With liquidity growth since the beginning of this financial year well below the targeted 15.5 per cent, interventions would tend to worsen the conditions in the markets. Traders said during the last week, although there was some intervention in the foreign exchange markets, they were “insignificant to check the rupee slide (against the U S dollar).“

Quantum mutual fund, fixed income head Arvind Chari said, “With markets in a liquidity deficit mode, we expect a reprieve from the 12 policy rate hikes that have occurred one after the other.“ However, inflation is presently hovering close to double digit and fears are that it could raise further exchange rate depreciation. Rating Agency CARE’s chief economist Madan Sabnavis cautioned, “Inflation will remain as the dominant concern.” Anticipating worsening liquidity, ahead of a stepped up Forex market intervention and a peak season, when credit offtake tends to rise, banks stepped up resource mobilisation efforts.

Banks borrowings through certificates of deposits increased.

Last week bank borrowings amounted to Rs 24,000 crore through CDs, a Rs 2,000-crore increase over the previous week.

Bulk of the subscribers to the CDs was from mutual funds, insurance companies, state governments and pension funds. This was in view of the high yields offered on CD funds. One year CDs

issued by public sector banks offer yields of 9.7 per cent.

Bank officials said CD resources mop up were in view of more increase in working capital from, oil, fertiliser, coal and other commodity importers in the coming weeks, with the rupee slide expected to continue. The slide triggered by events in Europe and the US was already worrying policymakers. The worry was articulated by the RBI’s governor D Subbarao at the Fund Bank meeting on Friday, where he said, “The two big flashpoints: Renewed anxiety in the US about recession and the deepening of the sovereign debt crisis in euro area. Each by itself is a big risk, but the bigger risk is that both could materialise simultaneously and interact with each other with adverse feedback loops manifested through trade, finance and confidence channels.” The crisis also led to heightened worries. HDFC Bank’s chief economist Abheek Barua said, “Banks see dollar as a safe haven and are not willing to lend them.” The reluctance to part with dollars has now led to a shortage of dollars, as capital flows thin out with the mounting crisis of confidence in emerging market economies including India.

The deterioration in confidence showed in the foreign exchange markets and manifested in the high spreads between one month forward rate and the nondeliverable (offshore trading of the rupee where settlement is in US dollars). One month later, dollar was priced at Rs 49.87 paise.

In NDF markets, dollar was priced higher at Rs 50.11. Financial markets are braced for another turbulent week.