When rates rise

SMARTSHRE

There is one simple way to understand the effect of an interest rate hike: look at supply and demand. Supply and demand is not a complete explanation but it's a fair starting point.

A rising rate makes money more expensive. That, in turn, constricts demand for loans and increases the supply of money for loans. At higher rates, lenders are more prepared to offer loans while borrowers are more reluctant to take them. This eventually cools off the real economy.

One important secondary effect is usually falling equity values. When rates rise, lenders divert funds from riskier assets (such as equity) into debt with its guaranteed returns. Equating debt yields with dividend yields, a drop in equity values seems justified "" debt yields rise and so must dividend yields.

Now, compare variable (floating) rates versus fixed rates in a scenario of rising inflation. If a smart long-term borrower reckons the economy is close to the bottom of a rate cycle, he should borrow at fixed rates. When inflation rises, the burden eases. On the other hand, if a smart borrower thinks the rate cycle is near peak, he should take floating loans.

This is a zero-sum game. A smart lender should attempt precisely the opposite; lend at floating rates near the bottom of a cycle and at fixed rates near the top of the cycle.

Now, until 2002, the concept of floating rate loans was unknown in India. Every debt instrument offered fixed returns. Over the next three years (2002-04), rates dropped.

In late 2004, rates started to firm up and this process is still continuing. Given the latest hike in US bank rates and the rising inflation in India itself, the rupee is likely to see another rate hike soon enough.

Perhaps coincidentally, floating loans became popular around 2002-03 and banks made the big thrust into retail at that time. Floaters replaced fixed loans over the next 4-5 years.

Amazingly, economic growth (and corporate earnings growth) was so strong that rising rates did not choke off liquidity to the stock-market. Nor indeed did credit off-take slowdown due to a booming economy.

Despite rising rates, huge sums have been disbursed over the past two years in floaters that funded real estate plays, consumer spending, other economic activity and outright speculation. Thus, we've seen a cycle where equity values have risen alongside interest rates.

What's fascinating is that this is the very first time that Indian debt has been predominantly in floaters. The cycle has not peaked yet. Lenders have won the zero-sum game since most of those floaters were taken nearer the bottom end of the cycle. In an immature market, lenders may have been a little too successful!

Defaults could occur over the next year or two if rates keep rising. Indeed, there's anecdotal evidence that default rates have already risen in the retail loans market. This would be the first whammy for lenders. The second whammy is that banks must accept some notional losses in marking portfolios down to market. That makes banks a very dangerous proposition for equity investors.

At the same time, all equity values will eventually be affected by rate hikes "" the instant the economy slows down, there could be another massive stockmarket correction.

The least affected will be cash-rich companies, which don't need working capital loans or collect their dues in floaters. That means the better FMCGs and the IT companies.