Where are the interest rates headed?

The only way is up

BANDI RAM PRASAD
Chief economist,
Bombay Stock Exchange

One thing that is common to two diametrically opposite sentiments between last year and this year is the interest rates. It is the direction that is making the difference.

Interest rates in the US have recovered from the 46-year low of one per cent this year. The Federal Reserve has raised its targets funds rate twice in the last two months. A decade ago in 1994, the Fed doubled the key rate to six percent within a year. One hopes that the same does not get repeated this time.

Meanwhile, many other countries are rolling up their sleeves to raise their interest rates. Australia and the UK have already done that.

In seven out of nine major economies, corporate bond rates have risen, and in 11 out of 24 emerging economies short term interest rates are on an uptick.

Evidence shows that interest rates affect business cycles in emerging economies and rate raises are associated with economic downturns. Cross-country studies indicate a strong negative correlation between interest rates and gross domestic product growth.

Rate raises adversely affect the personal debt and mortgages, both of which form a major chunk of the financial sector in several countries currently. The adverse effects of soaring interest rates are well researched and documented.

The moot question here is how India will manage it. Higher interest rates spell a problem for the financial services sector. In mature economies, household debt as a per cent of disposable income crossed 120 per cent in Japan and the US and is reaching 100 per cent in the eurozone. Savings as a percent of disposable income, meanwhile, touched as low as 25 per cent in the US.

Household debt in several major economies grew in the range of eight-ten per cent in the last seven years. Even in emerging economies such as South Korea, Malaysia, Thailand, bank loans to household sector form any where up to 20 to 50 per cent of the total outstanding loans.

In India, on the other hand, growth of household debt is still relatively an emerging trend. For instance, loans to consumer durables in India form less than 0.5 per cent of the total outstanding loans.

Higher interest rates would surely adversely affect the mortgages but they form about five per cent of the loans in India. Banks could manage with an effective credit-monitoring system. At least these segments are not big enough to create a systemic risk as the case would be in the case of some economies.

In the background of higher exposure to government paper, banks in India, particularly public-sector ones, might see some problem as interest rates begin to climb. Profits of Indian banks could come under pressure due to higher reliance on investments in the government securities.

More significant will be the effect of higher interest rates on the pace of the personal loans segment, on which many banks are looking at as a major revenue stream in the future. This, of course, could be overcome to a significant extent by effective loan management strategies.

Project investments in India grew by 11 per cent in 2003 compared with six per cent in the previous year. There could be a fear of the effect of hike in interest rates on the pace of further growth in project investments sector. However, it is too early to say that since the situation does not sound so alarming now.

Fiscal situation could become further vulnerable with debt servicing becoming costlier, given more challenges to the macro management of the economy.

More important is the fact that Indian economy has several enabling features that could help it managing the problem of higher interest rates which include: a growing and diversified economy, a relatively healthy household balance sheets, higher savings rates, balanced exposure of banking system, attractive valuations still prevailing in the equity markets, availability of risk-transfer instruments, and a well-established institutional framework. All these could come in handy for an efficient policy that is keenly intent on managing the impact of interest rates.

Views are author's own

No case for a hike now

KISHLAYA PATHAK
Economist-India,
Standard Chartered Bank

Monetary policy is faced with the task of supporting a strong investment revival. Having said that, it needs to be recognised that the overriding responsibility of any central bank is to ensure price stability by anchoring inflation expectations.

In view of the above, the key challenges facing the Reserve Bank of India (RBI) are imported inflation and the prospect of normalisation of monetary policy across the world. We are of the view that the RBI is unlikely to hike rates in 2004.

Early 2005 is a tricky call given the uncertainties involved. On balance, we still think that no hikes are likely before the second half of the financial year 2005.

It is now well understood that a large part of wholesale price inflation is imported in nature. Constrained pass-through of higher input costs to downstream industries and consumer prices is also a reality. The influence of globalisation and domestic deregulation in reducing pricing power across industries is evident.

That said, whatever the cause of the price rise, persistently high headline inflation is not acceptable given the possibility of spiralling inflationary expectations. The government has responded to this quandary by targeted fiscal measures, choosing for now not to touch the demand side.

We expect global commodity pressures to ease going forward. Chinese attempts to slowdown their economy are already bearing fruit-industrial production has slowed down from 19.4 per cent year on year in March to 15.5 per cent year on year in July. In addition, we expect US growth to moderate next year on the back of post-election fiscal tightening.

Another issue is raising the trend growth rate of the economy to about 8 per cent. For India, unlike in the developed economies, potential growth is not constrained by productivity augmented labour supply growth. A sustained increase in the investment-to-GDP ratio could result in higher trend growth.

While several factors impact investment activity, it is difficult to argue that low real interests are unimportant in aiding this process. In view of the above, pre-emptive counter-cyclical tightening has only vague connotations in the Indian context.

While domestic factors may argue for low rates, global monetary tightening will certainly impede RBI's monetary flexibility. The US Federal Reserve has made it clear that it will continue to normalise policy irrespective of economic data. Shrinking global liquidity will inevitably reduce capital flows to India.

However, this monetary cycle seems different in detail. First and foremost, the 'IT Revolution' has been a positive shock to the current account.

In our view, India has entered a phase of persistent current account surpluses. A capital exporting country is surely less vulnerable to drying up of capital inflows.

Secondly, interest rate differentials need to be viewed in the backdrop of exchange rate expectations. In 1998 and 2000, when forex concerns had forced the RBI to tighten its policy, an overvalued rupee had been the basic problem. Today things are different.

Globally, the dollar is stuck in a range. The huge US current account deficit implies structural depreciation, while monetary tightening is giving it cyclical support.

On balance, dollar strength looks unlikely and exchange rate expectations remain subdued. This is evident from the fact that implied rupee rates through the forex route are still below domestic interest rates.

Clearly, the forex market does not seem worried about higher dollar rates. In a nutshell, in the dollar weakness phase, non-dollar fixed income assets will remain attractive despite lower interest rate carry. This will give the RBI a wiggle room to manoeuvre and delay rate hikes.

Last but not the least, ruling out exceptional circumstances, fiscal tightening seems inevitable and the best policy option going forward. This will help in demand management and also release domestic savings for the private sector to invest.

The above should prevent significant widening of the US current account deficit even in the face of a huge investment surge, insulating the growth process from sudden swings in capital flows.