Keeping Things In Line

The two major aberrations of last year "� high interest rates and rising inflation "� seem to be in the process of getting aligned with other macroeconomic variables. The inflation rate increased from 4.5 per cent when P Chidambaram presented his first budget in July 1996, and reached 8 per cent in January this year. It appeared then that the economy was heading towards double-digit inflation. Contrary to expectations, though, the inflation rate has come down to below 7 per cent in the first week of this fiscal year. One reason for this is the softening of interest rates. Another is the refusal to go through with overdue hikes in administered prices, as in petroleum.

The sharp rise in prices from July to January was neither demand-driven nor induced by excess money. For, not only had industry slowed down but money was also tight. Apart from the initial cost push factors like the July hike in petroleum prices "� which was well absorbed by the system "� a basic factor which pushed up the price level was the high real rate of interest. This affected everything from the holding cost of inventories to the cost of fixed investment. To tackle this, the RBI, over the last six months or so, released massive amounts of liquidity at the short end of the market, sending short-term yields crashing. Compared to the situation last year, money is now almost free at 0.25 per cent to 1 per cent. Three-day repos are going at 3.5 per cent and 91-day Treasury bill yields have fallen to barely 7 per cent.

This excess liquidity has now started having an impact on long-term yields as well. The latest auction for 10-year government paper went at 13.05 per cent, a good 60 basis points cheaper than in the last auction in 1996-97. This has started rubbing off onto the corporate sector as well. SAIL intends to raise Rs 500 crore through five-year paper at a coupon rate of 14.75 per cent. This is a two percentage point drop from the going yields a fortnight ago. Yields in the secondary market for corporate debt have also dropped. This has happened because the vast pool of investible resources with banks has deluged the debt market.

While the banks may still be going slow on expanding credit against inventories, receivables and finished goods, the slack season monetary policy has induced them to deploy excess funds in corporate paper. This makes sense for a variety of reasons. For one, the yields compare well with lending rates, even though there is more safety in subscribing to corporate paper than lending against stock. Secondly, the yields are much better than in alternative avenues of deployment. Commercial paper, for insta-nce, fetches around 12 per cent. Three-month government paper yields but 7 per cent and even 10-year paper is trading at around 12.75 per cent in the secondary market. Thirdly, there is a reasonably well developed secondary market for corporate paper. This gives banks and others a ready exit option if they wish to cut back their exposure in a company. The result is that banks are queuing up to pick up corporate paper and yields are dropping. For the corporate sector, this is Manna from heaven, at least in the

short run. The situation today is certainly more optimal than last year and the Reserve Bank's strategy seems to be working.