A V Rajwade: Exchange and interest rates

WORLD MONEY/ There is a strong case for interest rates to go up in India

Not many people remember now, but about three months ago, just about everybody was looking at an exchange rate of Rs 42 "" or was it even lower? "" by mid-year. That figure looks way off now. This throws up a few points worth noting by students of financial markets:

Active market participants often fall into the trap of expecting an existing trend to continue indefinitely "" unfortunately, in real life, nobody can defy Newton forever;

Perhaps there is some wishful thinking involved, as well as active participants taking positions on trends;

There is personal and professional safety in going with the crowd "" you are rarely blamed if you are wrong with the rest of your peers;

Often, when the consensus on a given direction is practically unanimous, it turns out to be wrong. Keynes was so right in cautioning about the unexpected happening.

Another interesting point: one is often happier if one's judgement turns out to be right, than if it goes wrong through what is substantively an extremely favourable development. Take the state of mind of exporters who, expecting rupee appreciation to continue, had sold dollars in the forward market.

They are now unhappy "" they would have been happier if the exchange rate now was, say, Rs 42 a dollar because that would have proved their wisdom in selling forward!

Actually, the exporter should be happier with a rate of Rs 46 because this gives him much better margins on the unhedged exposures and indeed on future export business.

Interest rates: The party in bond markets worldwide also seems to be over. The Federal Reserve may well announce a rate hike later this week increasing the Fed funds rate from 1 per cent, where it has been for a year.

Earlier this month, the Bank of England engineered the fourth successive hike in its base rate over the past six months.

What the Fed or other central banks do would have only a limited impact on the monetary stance of the Reserve Bank of India (RBI) "" other analysts seem to give far greater weight to this factor in their expectations.

As readers of this column may recall, I have been an agnostic when it comes to the theory that interest arbitrage was attracting significant external funds to the Indian market.

But there is a new factor now "" namely, the window for residents to transfer money outside India. Surely, at some combination of interest differential and exchange rate expectations, residents would start transferring funds. And that would put pressure on the market interest and exchange rates.

Quite apart from this, there is a strong case for interest rates to go up in India. The last inflation number, based on data as of June 5, was 5.5 per cent. This level does not factor in the mid-June hike in petro-product prices.

By our historical standards, of course, the inflation rate need not be considered worryingly high, more so at a time when the prices of all commodities have hardened significantly over the past couple of years.

While oil seems to have stabilised a little below $ 40 a barrel, don't count on its remaining there: the political situation in Saudi Arabia and Iraq is fragile and the possibility of chaos and disruption of supplies can hardly be ruled out. Thus, there is a good chance of inflation continuing to rise and, overall, current bond yields may not be sustainable.

Capital indexed bond: The RBI is likely to float another issue of government bonds with the principal amount indexed to the inflation rate. The coupon will be constant in percentage terms, but the actual payout would be on the basis of the indexed principal.

The RBI's earlier issue of inflation indexed bonds, back in December 1997, did not prove popular because, as the RBI claims, the coupon was unprotected against inflation, and the pricing was complex. To my mind, there was a third reason, too "" the bonds were not marketed properly.

Inflation indexed bonds are ideal for senior citizens such as yours truly, as also for pension funds. Initially, such bonds were limited to the Anglo-Saxon world; lately however they have picked up popularity in Europe as well.

In the Netherlands, the Dutch pension funds find enthusiastic buyers since the pension amounts are inflation indexed. In France, too, the savings bank interest is linked to the inflation rate.

There is another advantage to capital indexed bonds from the viewpoint of the issuer, namely the government of India "" the issuer's revenues broadly depend on the nominal GDP and are, therefore, for all practical purposes, inflation indexed. Thus, inflation indexed liabilities have an automatic hedge "" it is like an exporter being safer with dollar loans.

As argued earlier, inflation indexed bonds are good investments for retirees and other senior citizens, provided the tax issues are clear. But, if government bonds are to find a retail market the RBI's department, which handles issues like the 6.5 per cent tax-free bond to retail investors, will need to be more use-friendly and simpler to follow, which today it is not.

My own experience has been far from smooth. The procedures are cumbersome, no pamphlet or document is given to the investors explaining them in a clear and transparent manner, and it often requires two to three submissions of the bond to get the maturity proceeds.

The process can often take a few weeks. And this in an era of electronic funds transfers. Here is a strong case for procedural simplifications and better customer service.

Email: avrco@vsnl.com