Dearer money

The sharp rise in wholesale price inflation to 5.5 per cent is yet another warning that interest rates could be on their way up.

The rise is all the more worrying because the inflation numbers are for the week to June 5, before the hike in petrol, diesel and coal prices. What's more, rupee appreciation will no longer cushion rising import prices.

As a matter of fact, the cost of borrowing has already gone up at the long end, with the yield on the benchmark 6.20 per cent 2010 UTI bond moving up to 5.5897 per cent, compared to 5.18 per cent a month ago. Rates at the short end too have hardened, albeit marginally "" six-month commercial paper rates have hardened by around 6 basis points this month for P1+ rated paper.

The slowdown in foreign funds inflows has already led to forex reserves dipping for the second consecutive week. This has implications for the bond markets.

The Reserve Bank of India (RBI) had pumped in huge amounts of rupee liquidity as a result of its policy of mopping up dollars, and now that dollar inflows are lower and the rupee is not appreciating, there is no reason for the RBI to buy dollars. Hence the fall in foreign exchange reserves, on the one hand, and a slow but steady movement towards lower liquidity on the other.

Currently, of course, ample liquidty continues to exist in the money markets, as the large amounts parked in repos show. But that liquidity will dry up as the government announces its new borrowing programme, as corporates draw down their investments for funding their expansion programmes, and as banks increase lending.

In the international markets, central banks in the UK, New Zealand and Switzerland have all raised interest rates, and the markets are expecting a 25 to 50 basis point increase by the US Federal Reserve at its meeting on June 30.

With the 10-year government bond at 5.5 per cent and inflation thereabouts, India's real interest rates are among the lowest in the world, and there's little doubt that they will go up.

Low interest rates have been one of the main factors buoying corporate performance in the past few years and, coupled with higher raw material prices, the higher cost of borrowing will take its toll on corporate bottom lines. Small wonder that companies are scrambling to lock in their borrowings at current interest rates.

At the same time, higher interest rates will also affect the mortgage, auto finance and other retail lending markets, pushing up borrowing costs for individuals. Bank performance in recent quarters has already been affected by the absence of windfall profits from sale of investments, and so far they have been unable to expand their lending sufficiently to make up for the lack of capital gains.

However, much depends on whether corporates can increase volumes sufficiently to make up for the reduced margins. It's also very likely that keen competition will ensure that interest rates on housing and other retail loans rise as little as possible.

Further, once companies start expanding capacity, investment demand will also kick in. Keeping the fiscal deficit under check will also help.

Nevertheless, there's no denying that the liquidity cycle has turned, and it's time the RBI prepared the markets for higher interest rates.