Rising rates

Rising rates threaten to suck out the liquidity from stock markets, slow down profit growth, and lead to de-rating of equities.

A report by Citigroup released in June revealed something startling. It said that over the past few weeks 19 central banks, accounting for over four-fifths of global GDP, had tightened monetary policy. That is unprecedented. Strong growth, resulting from an easy to accommodating money policy for the past two years and rising inflationary threat, is forcing central banks around the world to follow a tight money policy.

The recent changes in asset prices and the broad and more or less simultaneous reaction of monetary policy around the world, the Citi report said, raised basic questions on whether the global economy is facing an emerging inflation threat that will require a sustained tightening of monetary policy around the world and a period of sub-par global growth.

If that were indeed the case, it would be depressing for markets around the globe. Fearing sustained rise in rates, global asset market have been nervous since mid-May.

Last Thursday, however, as the Fed announced its 17th consecutive 25 basis point hike in Fed Funds rates taking it to 5.25 per cent, global markets breathed a sigh of relief.

On Friday, all prominent emerging market gained""Hang Seng (2.54 per cent), Jakarta Composite (2.79 per cent), Seoul Composite (2.54 per cent), Nikkei (2.54 per cent and Philippines Composite (4.52 per cent). India's Sensex gained 447 points.

Markets are probably saying, as the Citi report earlier said, that the Federal Reserve is near the end of a long period of monetary tightening and will raise rates probably only once more before pausing after the August meeting.

But, opinion remains divided. "The only uncertainty appears to be on how far the Fed will take its benchmark rates before it calls a halt to its tightening policy. (On balance of factors), it does appear that a tighter monetary regime is here to stay and this will likely prompt a re-adjustment of portfolio flows in the short-to-medium term," says K N Sivasubramanian, senior portfolio manager, Franklin Templeton.

Back home, marketmen are expecting a hike in the reverse repo rate""the equivalent of Fed rate""currently hovering at 5.75 per cent, in the near term. The threat of rising interest rates in the domestic economy seems larger than in the past two years with the narrowing interest rate differential between the US and India.

Besides, while inflationary concerns persist, the domestic economy is bubbling and a big chunk of the capital expenditure planned by corporates is expected to happen over the next couple of years.

"Real demand for money is yet to pick up with corporate expansion plans yet to move into a higher gear," says Prashant Jain, chief investment officer, HDFC Mutual Fund.

On the supply side, banks are running out of capital to lend and deposits are not growing at a brisk rate either. And if equity markets do not look up, plans to raise capital may go awry making money even more scarce. More demand for money, and short supply would only mean the price of money or interest rates must go up further.

But by how much? And how would this affect growth, corporate profits and stock prices?

Where are rates headed?
The compulsions for RBI to raise interest rates are more even though the differential between the US Fed and reverse repo rates here has narrowed to 50 basis points.

Two years back when the US Fed began raising rates, the differential was as high as 350 basis points. From 1 per cent in May 2004, Fed has hiked its rate 17 times, 25 basis points each. During the same time span, the Reserve Bank of India's reverse repo rate has been hiked from 4.5 per cent to 5.75 per cent""by 125 basis points.

Till November 2005, every percentage point hike in the US Fed rate was followed by a 25 basis points hike in the reverse repo rate but since then every 50 basis points hike in Fed rate is followed up with a 25 basis points hike in the reverse repo rate. "RBI will have to act faster to global changes in rates," says Sachidanand Shukla, economist at domestic broking firm Enam Securities.

Domestic compulsions seem to be weighting heavily too. Though prices aren't spiraling alarmingly, they are still rising steadily. In the 12 months through June 10, the Wholesale Price Index rose at a faster-than-expected rate of 5.24 per cent, due to an increase in the cost of fuel, food and manufactured products.

And the credit demand has been really strong while deposits growth isn't quite keeping pace. This fiscal, so far, bank deposits have shown poor growth at 1.7 per cent compared to 4.9 per cent in the same period last year.

But during the same period, non-food credit has grown at 33 per cent from Rs 11.01 lakh crore to 14.70 lakh crore. Reflecting the increased off-take, credit-deposit ratio has jumped from 55 per cent two years ago to over 70 per cent currently.

Thus banks have been raising lending rates. Prime lending rates which were at end-March mean level of 10.75 per cent are rising. Currently, the largest bank State Bank of India has a PLR of 11.25 per cent. Another 100 basis point hike in PLR is a foregone conclusion but there could be more depending on demand and RBI stance.

Marketmen believe that the central bank could use the cash reserve ratio as a weapon to release some money into cash strapped banks. It's worth recalling that RBI had cut CRR by 150 basis points in fiscal 2000 after foreign institutional inflows had turned negative in fiscal '99.

According to a report by Kotak Securities, a 50 basis points rate cut in CRR would release Rs 12,500 crore in the first round and Rs 60,000 crore in all given a money multiplier of five.

Credit off-take in fiscal 2006 was Rs 3,400 billion (Rs 3,40,000 crore) but resources available for interest rate neutral credit off-take is Rs 3,340 billion (Rs 3,34,000 crore). Kotak estimates that in the worst case, the credit off-take requirement could exceed resources by some Rs 8,000 crore.

Impact on corporate profits
Rising rates would eat into corporate bottomline but that may not be a big concern as long as rates do not go up more than say, two per cent from current levels.

Moreover, even after the recent increases in interest rates, lending rates are still far below the levels in the early nineties and are unlikely to climb back to those levels over the medium-term.

Interest rates are currently at the lowest ebb and some increase is only inevitable. Since fiscal 99, interest cost as a percentage of sales have gone down from 5.36 per cent to 1.75 per cent for the BS1000 companies.

But the good news is that corporate gearing is currently at a historic low falling from 1 in fiscal 99 to 0.62 currently meaning there is enough room to absorb increases in rates without too much stress on the bottomline.

Says Sivasubramanian, "Sensitivity of corporate earnings to higher interest rates has declined after the debt restructuring exercises undertaken by companies over the past few years, which has substantially reduced the leverage in balance sheets." Jain agrees pointing out that some pressure on profitability is a given.

The bigger question however is growth: whether corporates still go ahead with new capacities or will expansion plans take a backseat impacting growth rates. So far there has been no news of any deferment in corporate expansion plans due to the rise in cost of funding.

But then, it's not just cash with banks but the state of the equity market and the interest of foreign investors that will determine whether corporate plans are on track.

This time around, unlike in the early nineties, the bulk of funding has taken place through equity issues and internal accruals.

Last fiscal, corporates raised Rs 24,000 crore through equity and quasi-equity issuances and this year again non-bank issuances alone are estimated to raise around Rs 27,000 crore. FIIs will play a crucial role here.

For instance, FIIs are estimated to have accounted for more than a third of recent top 25 issuances, according to Kotak Securities.

While growth rates may slow, no one is projecting sub-10 per cent growth in earnings. Analysts say that an earnings growth of around 12-15 per cent over the next couple of years is achievable.

Will liquidity be affected?
One of the fallouts of the rise in Fed rates is the re-balancing of portfolios. Due to the increasing dominance of momentum investors across the global market and various asset classes, the impact of interest rates on flows tend to be even more pronounced.

Though there are hardly any numbers to show how much of the flow into emerging markets emanated from carry trades (low cost money raised in certain developed markets deployed in high rates in assets perceived as risky), fears of a rise in Japanese rates has already led to an exodus from emerging equity market and commodity markets.

During the five weeks of global sell-off and heightened volatility ending June 21, investors have pulled about $22 billion from equity funds belonging to all regions except US which record net inflows of $4.8 billion.

But is that all or there is more to go? Changes in liquidity flows are notoriously difficult to predict and it may be a tad too early to say that the re-adjustment has played out completely.

"With the interest rate differential slimming, money will move to its original source which means an outflow from emerging markets," says Shukla.

While maintaining that rising interest rates may prompt unwinding of the carry trade positions and that there might be increased volatility due to the change in sentiment, Sivasubramanian says, "Fundamentals will prevail over the long term. And strong economies like India offering attractive growth potential will continue to bring in investments."

There is another way to look at this too. In an earlier meeting, Adrian Mowat of JP Morgan Securities demonstrated that global liquidity was being generated in emerging markets, essentially as nine prominant emerging markets, including China, Korea, Hong Kong, Philippines, Taiwan and Singapore had short term rates lower than that of the US indicating a negative interest rates differential and in several other economies like Russia, Thailand, South Africa and India differential had fallen sharply.

Mowat said that risks are falling in emerging markets even as they offered higher growth. "Structural problems were a feature of developed rather than developing economies as the emerging markets provided capital, steadier domestically driven growth, relatively inexpensive valuations and better capital management," he indicated.

What about sentiment and stock prices?
More than corporate earnings, interest rates affect stock valuations due to changes in the risk premium.

When bond yields were going at 5 per cent, the bond multiple stood at 20 and a similar multiple for stocks may have been easily justified. But with bond yields shooting up to 8 per cent, the multiple for risk free assets is down to 12 times making an equity valuation of 15 times earnings look expensive.

Says Jain, "Between corporate earnings and discounting, the bigger concern is valuations as higher interest rates make equities look less attractive than before."

The good news however is that the markets usually take time to react to such interest rates changes.

For instance, for a long time after interest rates had bottomed out, equity markets did not show a spurt in valuation. It took billions of dollars of foreign money to unlock the value in stocks thereafter.

Where to invest
The blessing in disguise is that rising borrowing costs will have an uneven impact across sectors and companies.

Says Sivasubramanian, "Certain businesses such as FMCGs are characterised by low levels of debt and significant operational cash flows and will face negligible impact from rising borrowing costs. We see the possibility of reducing the impact from higher borrowing costs on our portfolios through stock selection."

While an overall derating of equities is inevitable, if rates continue to be high, safer havens would be technology and consumer stocks which are debt-free and companies that are net cash positive.

As things stand now, experts do not expect rising borrowing costs to have an impact on consumer spending and confidence.

"Spends on staple or even durable goods may not be significantly impacted by rising rates, as income levels have expanded significantly over the past few years, with loan repayments making up a smaller proportion of the income," says Sivasubramanian.

However, he says, rising interest rates could have a material impact on big-ticket purchases such as homes given that the bulk of housing loans are disbursed on a floating rate basis.

A slowdown in housing loan disbursements cannot be ruled out if interest rates continue to trend up, accompanied by spiraling property prices. The appetite for residential housing is likely to be sustained thanks to an expanding workforce and easy access to credit.