Tamal Bandyopadhyay: Is the honeymoon over?

As rates rise, the government is likely to be hit harder than the banks and corporate sector

The yield on the 10-year benchmark government paper rose to 5.82 per cent on Wednesday. This is over 88 basis points (one basis point is one hundredth of a percentage point) higher than its historic low of 4.94 per cent, recorded in October last year.

With the prices of government bonds, particularly at the long-end, crashing by over a rupee in every trading session over the past few days, the 10-year yield could end up touching 6 per cent in a few days. Finally, like all good things in life, the four-year honeymoon of Indian markets with low interest rates is coming to an end.

Since October 2000, the 10-year government bond interest rate has fallen by five percentage points. The story of medium- and short-term paper is no different. The five-year bond rate that was 9.5 per cent in March 2001, dipped to 4.64 per cent last October. Now, it is inching towards 4.50 per cent.

Similarly, at the shorter end, the one-year dated government security that was trading at 9.02 per cent in March 2001, dropped sharply to 4.20 per cent in October last year. This week, it is veering around 4.65 per cent.

These rates are market determined. Here's a look at other rates set by the Reserve Bank of India (RBI). There are three rates in this category: bank rate (the rate at which the Indian central bank offers the refinance facility to commercial banks), repurchase or repo rate (the rate at which the central bank temporarily sucks out liquidity from the system) and savings bank rate (the only administered deposit rates).

Between January 1998 and now, the bank rate has dropped from 11 per cent to 6 per cent. Since the RBI introduced the repo facility in mid-2000, it has fallen from 7 per cent in July 2000 to 4.5 per cent. The drop in savings rate over the past few years has been less spectacular "" from 4.5 per cent to 3.5 per cent.

The RBI is sure to wait awhile before raising these rates but that does not deter the market rates. RBI governor Y V Reddy, in a recent interview to a newspaper, said that the rates are hardening globally and there could be a case for revisiting the interest rate stance. At the same time, he has hinted that it may not happen too soon.

Here is what Reddy said: "...Taking into account the contextual factors, global as well as inflationary, there probably was a case for reducing rates at that time (November last year). But it was deliberately not done by us in the expectation that the global situation might change. The monetary stance of May ought, therefore, to be viewed in the context what we did or did not do in November. By not reducing the interest rates then, we avoided some of the problems of reducing rates then and increasing them later...

"In November there was an expectation that global interest rates could go up and that liquidity might dry up. To some extent, those have materialised. Taking into account the November and May statements together, we were correct in continuing to emphasise the domestic factors. However, if global trends exceed what we have assumed, there would be a case for revisiting them. Between May 18 and now (June 14) there is certainly evidence of interest rates hardening in the developed world. Financial markets are already factoring this in."

So, the domestic rates will be revised upwards by the RBI if the global rates start rising too rapidly. This may not happen as US Federal Reserve Chairman Alan Greenspan has been talking about a "measured" approach towards a rate rise. The Federal Reserve rate has come down to a four-decade (since 1958) low of 1 per cent through 11 rate cuts.

In the same fashion, it is likely to crawl up in phases and not zoom overnight. The benchmark bank rate in India has also come to its three-decade (since 1973) low of 6 per cent from 11 per cent in January 1998 through nine cuts and two hikes. It will not start galloping suddenly.

A rise in rates will affect all constituents of the financial sector "" borrowers (both corporations and retail), the banks and the government. Here's a close look at the likely impact on these three segments.

Borrowers: The biggest beneficiary of the low interest rate regime has been Indian Inc. According to a Business Standard Research Bureau study, the listed companies saved close to Rs 8,400 crore over the past three years. This was largely done by replacing high-cost old debt with new low-cost liability.

A Centre for Monitoring Indian Economy (CMIE) study "" which covered all companies including the unlisted one "" has pegged the figure at Rs 10,000-11,000 crore. With the first signs of rising rates, corporations should shift from floating rate to fixed rate loans, says Y M Deosthalee, chief financial officer of Larsen & Toubro. He feels that the rates have bottomed out and from this level they can only go up.

This is the case with the retail borrowers, too. A sizeable part of the new home loans are being raised at fixed rates. Even those who have raised retail loans at floating rates will not feel the pinch immediately because the floating rate loans are structured in a way that with a change in rates, the quantum of equated monthly instalments (EMI) does not change.

In other words, the monthly cash outgo of a retail customer towards the payment of loan instalment remains the same. However, the maturity profile of the loan gets longer. How is this done? An EMI has two components: payment towards principal amount and the interest component. When the rates go up, the interest payment goes up within the overall EMI while the principal amount gets repaid over a longer period of time.

Banks: Theoretically, the banks can have the best of both worlds. In a low interest rate regime, they make money on government bonds and when rates go up, the money comes from the interest income on their loan book.

Over the past few years, the single largest contributing factor to Indian banks' bottomline growth was treasury income. As the rates rise, that income will go down drastically. The interest income may not be able to compensate this unless there is a spectacular credit growth.

The banks are indeed running the big risk of serious asset-liability mismatches by playing the bond game. The average duration of the outstanding government of India debt could be over six years while the average duration of banks' deposit liabilities is less than two years. A one percentage point upward shock (that is if the yield goes up and prices come down by one percentage point) can knock off over Rs 3,000 crore from the banks' bottomline.

To cushion this shock, banks have been directed to create an investment fluctuation reserve (IFR) out of the gains from bond sales to the extent of 5 per cent of their portfolio over a period of five years. But this provision does not distinguish between banks' exposure to short- and long-duration papers. An industry study on interest rate movement has found that some of the banks can lose over 25 per cent of their equity capital in the event of a 320 basis points rise in government bond rates.

Senior bankers, however, feel that banks' bottomline will remain largely unaffected even if the bond rates rise by 1-1.5 percentage points. Any rise, higher than this, will have a bearing on banks' bottomline.

Government: The largest loser in a rising interest rate scenario could be the government. Over the last eight years (since 1995-96 when interest rates reached its peak), the weighted average cost of the government's borrowing programme has drastically come down from 13.75 per cent to 7.34 per cent (in fiscal year 2003).

Taking advantage of the southward movement of the interest rates, the government during this time stretched the average maturity of freshly issued papers from 5.7 years to 15.8 years. Any hike in rates will raise the government's borrowing cost and, in the process, widen the fiscal deficit. At this juncture, Manmohan Singh's new government can hardly afford this.