Is the time ripe for RBI to raise rates?

DEBATE

Even those in favour of a hike recommend a gradual move so that growth is not choked off as it happened in the late 1990s

Rupa Rege Nitsure
Chief Economist,
Bank of Baroda

Fundamentally speaking, interest rates have certainly developed a sharp upward bias at the longer end in India. However, the real question is not about the "direction" but about the actual magnitude of increase.

Though at its current level, the headline wholesale price index (WPI) inflation rate (5.26 per cent on a year-on-year basis) looks moderate, inflationary expectations are slowly building up.

Around the world, inflation risks have been increasing commensurate with higher energy prices. There have been indications that a rise in the domestic auto fuel prices is on the cards.

This combined with the pressure on commodity prices, especially steel, will pull upwards the domestic inflation rate sooner than later with its obvious implications for the market-determined interest rates.

Moreover, considering higher fiscal deficit in absolute terms and completion of the debt swap scheme, the Reserve Bank of India (RBI) in consultation with the government has proposed higher borrowings of Rs 83,000 crore in the first half of financial year 2006, compared to Rs 54,000 crore in the first half of financial year 2005 and a total borrowings of Rs 80,000 crore for financial year 2005.

In response to the announcement of higher supply of G-Secs and the announcement of sale of securities, the bond prices have weakened considerably in recent weeks.

Although there is rich liquidity in the system to absorb the auction, market participants would certainly charge a premium for taking an interest rate risk in view of the higher supply.

Thus, going forward, long-term interest rates in the G-Sec market are likely to move upwards.

So far as the lending rates of banks are concerned, they are influenced by more complex forces. Perspectives about the overall economic performance, expectations of potential loan receivers as well as heightened competition in the marketplace would play an important role here.

World over, lending rates are determined in negotiations and have a close relationship with the actual cost of funds for a specific intermediary.

In a nutshell, these rates are set within institutional agreements. However, the monetary policy of the Central Monetary Authority is one of the most powerful factors impacting these agreements.

To understand the future movement of lending rates in India, one needs to look at the macro backdrop closely. In the second half of financial year 2005, the Indian economy marginally slowed down amid a drought-induced contraction in the agricultural sector.

However, with industry and services fuelling growth, the economy still could register a growth of over 6.5 per cent in the year as a whole. The bright spot was that the country witnessed a long awaited recovery in business investment.

Even under the shadows of rising international oil prices and domestic drought, the RBI could facilitate the growth tempo by ensuring enough liquidity in the system with a close watch on price volatility.

In its mid-year Policy Review in October 2004, the RBI marginally raised the short-term repo rate by 25 basis points to signal an upward bias in interest rates.

Commercial banks did respond by raising their own deposit and lending rates but the actual increase was not very sharp. A higher cost of borrowing post-October 2004 did not weigh down on non-food credit demand.

For the year as a whole, non-food credit expanded at an unprecedented rate of 27.6 per cent, fuelling industrial recovery.

Though long-term interest rates have developed an upward bias in India, I think the RBI in its forthcoming Annual Monetary Policy will give signal for a gradual and not sudden rise in interest rates during the coming months in the interest of the ongoing industrial recovery.

As shown by the noted monetary economist, S L Shetty, in one of his research articles on "Money Market" in Economic and Political Weekly, many corporates from the public and private sectors are still struggling with servicing of past high-cost loans raised by them (post 1995-96 Monetary Policy), which have adversely affected their balance sheets.

The balance of considerations suggests that the RBI will give signal and/or create conditions for a gradual and moderate rise in interest rates to protect the present growth momentum.

P Mukherjee
Senior Vice-President,
Treasury, UTI Bank

With the credit policy around the corner, we are back to speculating on the direction that the Reserve Bank of India (RBI) governor will give to interest rates. One can say that this speculation is quite legitimate though others might aver that it is quite unwarranted at the moment.

Let us examine the state of the markets as well as that of the economy at this moment. Purists may take the stand that the state of the markets should not influence decisions on interest rates though Bond Street might violently beg to differ.

Keeping in mind the concerns of purists, we might state that the economy is cruising along at a gentle canter. Inflation is under control though concerns on the future of oil prices cannot be wished away.

Considering the pace of growth and the projections of the government, I doubt if the central bank would wish to take any action that could spike even the present rate of growth. The government might even look to the RBI for signals on easing to give growth a leg up.

Although the central bank has raised rates by only 25 basis points over the last year, this has already affected corporate loan rates by 50 to 100 basis points, with a small time lag. The bond markets were the first off the block in reacting.

Bank deposit rates were the next to react. Bank lending rates were the last to react. In fact, we can say that they are still reacting. A reaction to another rate hike, even if it is small, could be more immediate and violent.

It could also precipitate a shift in preference from loans to short-term investments in government securities and commercial paper, which might not be what the government or the central bank, is looking for. The impact on the retail boom could also be quite big.

Six months ago, there was genuine concern that liquidity in the markets was driving inflation.

That concern has passed and many would say that the liquidity in the market is only just the right amount. The average amount going into the Liquidity Adjustment Facility (LAF) is around Rs 35,000 crore.

This is not a staggering amount. In fact, the reaction to the last auction is ample testimony to the extreme gloom and pessimism in the markets, largely on the extent of liquidity that is available in the system to take care of the spate of auctions that will follow.

The bond markets are down quite markedly. Liquidity in this segment of the market has dried up almost completely. The number of participants willing to take positions is down drastically.

Understandably so, as it is extremely difficult to form a reasonably coherent interest rate view for the short, medium and longer terms. In the not-too-distant past, the market used to take a stand on the likelihood of a few financial institutions entering to buy.

Since then, over the past few years, a number of participants "" banks, primary dealers and mutual funds "" established themselves as serious players who would take large positions. As the result of the violent swings in interest rates over the last year, the ranks of the active participants has depleted sharply.

Considering that yields in the debt market have already moved up significantly, the RBI does not really have to push things up further. Market forces can now be trusted to arrive at a level of equilibrium in the matter of interest rates.

In fact, the central bank can take comfort from the fact that the "irrational exuberance" of the markets has been curbed without large-scale direct monetary action from the bank.

In fact, we are now passing through a "withdrawal phase" which may prompt some to wonder if the cure was not overdone.

It should be noted that the yield curve has steepened considerably over the last year. The overnight rate trades at around 4.50 to 4.75 per cent, which is quite reasonable.

A rise in interest rates would have to impact the shorter-end first. I expect that this might actually result in smoothening the curve, making it flatter.

The immediate impact would be an increase in the central bank's and the government's borrowing costs besides running the risk of seriously jeopardising the borrowing programme and also risking damage to the health of financial institutions, which have already had a torrid time over the last three quarters.