| The Reserve Bank of India (RBI) raised its nominal reverse repo rate (the interest rate at which the RBI absorbs funds from banks under its Liquidity Adjustment Facility) for a third time in 2006 to 6 per cent on July 25. On August 18, the Central Bank of China raised interest rates for a second time in four months raising the nominal deposit and lending rates by 0.27 per cent to 2.52 per cent and 6.12 per cent, respectively. In contrast, on August 8, the Federal Reserve of the US, after 17 successive interest rate hikes since June 2004, left its target for the Fed Funds rate (the nominal interest rate charged by banks from one another) unchanged at 5.25 per cent. |
| Around the world, such central bank decisions on changes in key nominal interest rates are invariably followed by supporting/dissenting remarks from market observers. In India, the recent discussions on interest rate changes also touched upon the independence of the RBI in setting monetary policy. The inevitable differences of opinion are centred on projected growth rates and anticipated inflation. In this context, comments on nominal interest rate changes usually do not track the corresponding impact, if any, on real interest rates. |
| In this article it will be argued that: (a) in cross-country terms current real interest rates on Government of India (GoI) fixed-income instruments are not that high since these are lower than comparable rates in the UK, the US, and Germany and are about the same as in China and Japan; (b) the GoI should issue long-term inflation-linked bonds (ILBs) on a regular basis. |
| Real interest rates are linked to nominal rates by the following relationship: (1 + R) = (1 + N)/ (1 + I), where R is the real interest rate, N the nominal rate and I is inflation. For low values of N and I this can be simplified to: R = N - I. That is, the real rate of interest is equal to the nominal rate minus the rate of inflation. This is a simplification since interest rates at the short end of the yield curve have different day count conventions, from medium- to long-term interest rates, and bonds invariably carry semi-annual coupons. The technically correct way to arrive at real interest rates would be subtract inflation rates from corresponding maturity zero-coupon interest rates. |
| The table above lists sovereign interest rates and consumer price inflation (CPI) numbers in India and a few other countries in 2001 and 2006. It could be argued that wholesale price inflation (WPI) numbers are a better input in estimating real interest rates but the CPI works as well for purposes of comparing rates across time/countries. |
| One of the crucial drivers of Indian growth in the last several years has been the relatively low cost of capital as compared to the 1990s. Further, the profitability of firms, dependent on debt capital, is directly correlated to borrowing costs. Consequently, concern has been expressed that growth and corporate earnings in India will be choked by this rising cost of capital. It can be seen from the table that nominal and real interest rates in India were lower as of August 18, 2006, than in 2001. In relative terms across countries, real interest rates are currently lower in India compared to the US, Germany, and the UK, and about the same as in China and Japan (at medium-term maturities). However, domestic borrowing costs for Indian firms are comparatively high but that has more to do with systemic inefficiencies in our financial sector. |
| Interest rates on government securities listed in the table, if plotted, would result in upward-sloping yield curves for India, Japan, China, and Germany and those for the UK and the US would be downward-sloping. That is, forward starting domestic medium to long-term nominal interest rates are expected to be lower than current rates in the UK and the US and higher in India, China, Japan and Germany. Effectively, if real interest rates remain at current levels, inflation (and possibly growth) rates are expected to be lower in the UK and the US compared to India. |
| Inflation varies over time in an unpredictable manner. It follows that it is difficult for individual firms to structure hedging strategies against unexpected inflation. By definition, a sovereign is best placed to model future inflation. Therefore, the GoI should signal its intention to contain inflation by issuing ILBs periodically as per an announced schedule and thereby also provide a hedging instrument against unexpected volatility in nominal interest rates. Any difference of perception between investors and the GoI about the seriousness of the latter's commitment to containing inflation would show up in the yields in the secondary market for ILBs, which would be a useful feedback mechanism. |
| The UK has been issuing ILBs since 1981; the US, Sweden, Canada, and Australia from 1997; and France, Italy, and Japan have joined more recently. In August 2005, the UK issued the first ever 50-year maturity ILB. However, it was not clear that there would be adequate demand and hence the UK Debt Management Office (DMO) chose to syndicate the bond rather than issue it through an auction. |
| In 1997, the RBI issued a 5-year maturity capital-indexed bond (the principal was inflation-protected but not the coupons) but investors were not that receptive. It is likely that the market was not convinced that the yields offered were adequate. It appears that in 2004 another ILB was issued by the RBI with inflation protection for the principal and the coupons. All things considered, the GoI needs to increase its issuance of ILBs in a phased manner. |
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