Is the low interest rate regime over?

ISSUE

50/60 bp rise by year end

Shubhada M Rao
Economist (Risk Management), BoB

In his recent testimony on the US economic outlook, Federal Reserve chairman Alan Greenspan cautioned the markets of an imminent, though not immediate, pressure on interest rates.

The barrage of strong economic data in April has already pushed up the US 10-year treasury yields by nearly 75 basis points from 3.75 per cent in end-March to 4.50 per cent in end-April. What implication does this have on interest rates in India? Evidence suggests that yields in India follow the direction of the US treasury yields, but with a lag.

Since the Indian economy is not yet completely integrated with the global economy, the factors affecting domestic interest rates are not driven by global economic conditions alone.

In India, strong economic recovery seen since last year is expected to consolidate further in the current year as well.

With near-full capacity utilisation levels in many sectors, private investment is poised to grow significantly with the economy adding new capacities, thereby suggesting a revival of investment demand, which in last two years has been relatively insignificant.

Add to this, the situation of growing government debt and therefore the pressure on government to borrow more in the economy. The combined forces of demand for funds will exert upward pressure on interest rates.

However, in the current scenario, unprecedented capital flows in the economy through hedge funds and NRI inflows have resulted in liquidity overhang, which has hitherto postponed any immediate upward pressure on interest rates.

Going forward, a sustained recovery in global economy with global growth expected to be around 4.6 per cent in 2004 and 4.4 per cent in 2005 (World Economic Outlook, April 2004) we may see some of the capital flows into India slowing in the coming months.

Furthermore, with recent RBI measures, NRI inflows too may see some slowing down. The current account balance is most likely to see a wider deficit with growing imports. That interest rates now have an upward bias in India. But when do we expect interest rates to rise?

The annual average inflation in FY04 was 5.5 per cent, which is considerably higher than seen in the previous year (3.5 per cent). The manufacturing prices are on the upswing.

Likewise, the domestic fuel prices are expected to rise soon after the general elections are concluded. As such, inflation is not likely to decline significantly in the current year. Inflationary expectations will thus exert pressure on interest rates.

Liquidity overhang emanating from foreign exchange inflows will be subdued as capital inflows slow down. We expect interest rates to start firming up towards the second quarter and close the year with a 50-60 basis point increase. The credit policy to be announced on May 18 is expected to spell out such concerns.

The key developments in the global economy like the measures taken by China to cool its overheated economy and closer home, the outcome of general elections will have significant and far-reaching implications on economic recovery and thereby the interest rates in India.

(These are the author's views and do not necessarily reflect the views of the organisation she represents.)

10-yr yield seen at 5-5.3%

M A Ravi Kumar
Regional Head, Global Markets, StanChart

The Federal Reserve of the US has kept its key funds rate at an unprecedented 1 per cent since June 2003 to alleviate the threat of deflation. Huge over-capacity plaguing the US product and labour markets has been the key driver of deflationary concerns.

The focus of monetary policy has been to ensure strong growth in order to absorb the excess capacity and labour market slack quickly. Growth has been strong by all means, but the job market had been the missing link in the US recovery story. The non-farm payrolls data for March put an end to the chorus of 'jobless growth' and deflation fears.

The market consensus now is that some of the exceptional stimulus is likely to be taken back in the second half of 2004. A 25 basis points rise in Fed Funds rate is likely over the next three months followed by additional 75 basis points before the end of the year.

The prospect of monetary tightening in the US has given rise to fears that capital flows to emerging markets might dry up, adversely impacting asset markets. There is a need to put the discussion in context. Post elections, we expect tighter fiscal policy to assume the burden of demand management in the US, implying only modest interest rate hikes by the Fed.

The funds rate will probably peak at around 3-3.5 per cent in this cycle. Coupled with that is the likelihood of continued dollar weakness due to the 'twin deficit' problem. So far the US dollar has weakened largely against the majors. Asia has bucked the trend by conducting heavy foreign exchange intervention. Once the Fed starts hiking rates, the dollar will probably stabilise against the majors.

However, as growth gains a firm foothold in Asia, we expect regional Central Banks to increasingly yield ground and let their currencies appreciate to aid the re-balancing of global demand.

Thus, monetary tightening in the US is unlikely to be severe.

What does this mean for Indian financial markets? External sector strength has been the defining force in all the markets. Strong portfolio inflows have driven the Sensex higher. Burgeoning foreign exchange reserves have underpinned confidence in the Indian rupee. Part sterilised intervention by the RBI has led to an increase in domestic liquidity, which has supported the local bond market.

While the broad Asian paradigm applies to India as well, country specific factors will also play an important role in defining the end-game for domestic financial markets. The India story is alive and kicking.

That should keep inflows strong despite a reduction in the quantum of flows to emerging markets as a whole. That said, a fractured electoral mandate and its implications for the pace of reforms could dampen sentiment, but only marginally.

To summarise, dollar weakness should continue to drive the rupee's strength. We see the Indian unit at 42 per dollar by 2004 end. Inflows might reduce at the margin but the possibility of a reversal seems remote. Domestic liquidity situation is unlikely to change materially. We see the 10-year yield range bound between 5 per cent and 5.30 per cent.

(These are the author's views and do not necessarily reflect the views of the organisation he represents.)