Inflation jitters bared

The CRR hike will steepen the yield curve

Bond prices slipped on Monday, wiping out last week's heroic efforts by banks to move bond yields down. The yield on the ten-year bond had been beaten down from around 6.6 per cent to around 5.9 per cent, ironically at a time when inflation was moving up.

The story was that inflation is going to come down anyway and the RBI would do nothing to spoil the party. Well, by raising the CRR, the central bank has signalled that it is worried about inflation, and that it believes that not all of the price rise is cost-push or "imported." So shouldn't the 10-year yield go back to around 6.6 per cent?

Money supply overhang

Why the change of tack by the RBI? One reason could be the fact that money supply (M3) growth is currently around 15.5 per cent, on a year-on-year basis, compared to a comparable growth of 11.9 per cent at the same time last year.

True, if the fiscal year is taken instead, M3 growth rate is lower than in the comparable period of last year. But that's because of slower growth during the first two months of the fiscal year.

If we take the period June 25 to August 20 (the latest date for which RBI data is available), the rise in money supply has been Rs 29,587 crore.

Compare that to the increase of Rs 16,432 crore over the same period last year, and it's easy to see that money supply growth has been high in recent weeks, and there's a need to suck out some of that liquidity.

Secondly, while it's true that rising oil and commodity prices have stoked inflation, and the central bank can do little about these factors, that is true for inflation all over the world. Yet that hasn't stopped the Federal Reserve from raising interest rates.

What is the RBI signalling by raising the CRR but keeping the repo rate unchanged? Raising repo rates in conditions of abundant liquidity is meaningless, because all that will happen is that banks will park more money with repos and RBI will have to pay more.

The central bank must therefore ensure that liquidity is sucked out before raising the repo rate. The effect of keeping the repo rate unchanged while mopping up liquidity will be to steepen the yield curve, as yields on longer-term bonds will rise.

Interest rates and banks

Will interest rates rise? It's important to realise that a higher CRR means that banks have less funds to lend at market rate, which means that they will have to increase the rate of interest on loans if they are to keep the same rate of return.

Banks will also increase their sub-PLR rates of interest to reflect the rise in market rates, although they may not raise prime lending rates. And if inflation is not tamed, credit continues to pick up and the promised investment boom materialises, there's little doubt that interest rates will rise across the maturity spectrum.

What will be the effect of the CRR hike? Banks will have to mark to market their portfolio at lower prices, and may have to take a bigger hit when transferring securities to the "held to maturity" category.

In any case, SLR securities held in excess of the 25 per cent stipulation will be hit. That's apart from their impact of the hike on bank profits because of the lower remuneration on CRR balances.

Paint companies' margins under pressure

Domestic paint companies are feeling the heat of rising petrol prices. Most companies have seen their margins come under pressure, with around 30-50 per cent of the raw material costs directly related to the petrochemical cycle. The impact of higher prices is being realised now as monthly contracts signed in August, are being executed now.

Although the paints industry did get some relief from the reduction in customs duty from 20 per cent to 15 per cent on petrochemicals, the spike in crude prices has offset the benefit. Companies which manufacture industrial paints have been impacted more, with almost 60 per cent of their costs based on crude oil prices.

There was a slight increase of around 1.5-2 per cent in the prices of solvent-based paints in the month of July, compared with a 10-15 per cent increase in the price of solvents in the last few months.

However, paint prices have remained more or less stable in the domestic market, with companies not passing on the increase in costs to the consumer. Demand has been growing at a healthy rate of around 10 -12 per cent and as price elasticity in some of these products is very high, any steep price increase is likely to impact the demand.

Since it is the beginning of the season for the paints sector, companies are more than wary to announce any price hikes, lest it upsets the 'apple cart', even if it means a considerable impact on their margins.

With contribution from Mansi Kapur