Tamal Bandyopadhyay: Interest rates will rise, whatever Reddy does

The huge government borrowing programme and redemption of the India Millennium Deposit, to cite just two reasons, will make this inevitable.

"We will work with the Reserve Bank of India board to ensure that there is price stability and inflation is kept under control. I have also requested the bank to keep interest rates benign and helpful to investment."

"" Finance Minister P Chidambaram in Delhi on March 2,
after a customary post-Budget meeting with the RBI board.

Will RBI Governor Yaga Venugopal Reddy oblige the finance minister when he unveils the annual monetary policy today? Or, will he make the government pay for its market borrowing by hiking the rate of reverse repo (through which the RBI sucks out liquidity from the system) by 25 basis points (one basis point is one-hundredth of a percentage point).

After all, he needs to tackle the higher inflationary expectations, increasing demand, and an exceptional credit growth.

In the first three weeks of the fiscal year, the RBI has raised Rs 15,000 crore from the market at yields that did not disappoint bond dealers. Will he take this forward and oblige the market expectations?

A recent report from Barclays Capital, the investment banking division of Barclays Bank Plc, has said a 25 basis point rate hike had been priced in by the market for the credit policy announcement.

In his last policy (in October 2004), Reddy had hiked the reverse repo rate by 25 basis points to 4.75 per cent, but left the benchmark bank rate untouched at a three-decade low of 6 per cent.

Ahead of that policy, he had hiked the banks' cash reserve ratio (CRR) by 50 basis points in two stages to 5 per cent to tackle the rising inflation.

The 50 basis points hike in CRR had sucked out around Rs 8,750 crore liquidity from the system.

A recent JP Morgan report has listed five multi-year "firsts" in 2005 that will pose challenges to policy- makers. Among these was the caution that for the first time in several years, the government is likely to undertake its entire market borrowing in an environment of rising local interest rates, and that the current account balance will slip into the red for the first time in five years.

Let us take a closer look at the backdrop against which Reddy will announce his policy.

After a gap of eight years, yields on government securities were higher at the end of the fiscal year (2004-05) than they were at the beginning.

The yield on the benchmark 10-year government security "" a barometer for interest rate movement in the gilts market "" had risen by over 1.5 percentage points during the year (from 5.12 per cent at the beginning of the year to around 6.65 per cent).

In contrast, the yield on the benchmark 10-year paper had dropped by about one percentage point (from 6.09 to 5.12 per cent) in the previous year.

This has been the story since 1996-97, when the yield on the 10-year paper dropped by about 60 basis points.

The sharpest fall was in 2001-02 when the yield dropped by close to three percentage points (from 10.32 to 7.47 per cent). Overall, the yield on the 10-year paper has dropped from a high of 14.01 per cent in April 1996 to around 6.65 in end March 2005.

It did cross the 7 per cent mark to reach 7.31 per cent in the course of the year, but then dropped subsequently. It dropped to its lowest level on October 16, 2003, when it touched 4.95 per cent.

The yield on 10-year paper has been veering around 7.12 per cent. The yield on five-year government security, which was 6.37 per cent in November last year, has now increased to 6.70 per cent.

However, at the shorter end, the yield has actually dropped, making the curve steeper. For instance, the yield on 364-day treasury bill, which was 5.71 per cent in November last year, has dropped to 5.65 per cent.

Finally, the yield on 91-day treasury bill has dropped from 5.50 to 5.12 per cent during this period.

Global rates during this time have firmed up more sharply. The US Federal Reserve has hiked its base rate from 1 per cent in June 2004 to 2.75 per cent now through seven hikes. In contrast, the RBI has hiked its reverse repo rate only once, to 4.75 per cent, and it is only 25 basis points higher than its lowest-ever level of 4.50 per cent.

The rising rates, however, did not impact credit growth last year. The credit portfolio of the banking system grew by Rs 2,26,44 crore or 26.2 per cent in 2004-05 against a growth of Rs 1,10,253 crore (14.8 per cent) in the previous year. This is the highest ever annual credit growth recorded by the Indian banking system.

The wholesale price index-based domestic inflation had surged to a 3.5-year high of 8.74 per cent last August, on account of higher oil prices. Since then, it has been on a downward move.

In fact, it dropped to 5.05 per cent last month but subsequently increased to touch 5.48 per cent for the week ending April 9.

On the positive side, there is ample liquidity in the system. Commercial banks have daily been parking on an average of over Rs 30,000 crore at the RBI' s reverse repo window.

Taking into account the market stabilisation in securities and the government's balance with the central bank, besides the reverse repo bids, the surplus liquidity in the system could be over Rs 1,00,000 crore.

However, the liquidity will tighten with the outflow of over about Rs 24,000 crore ($5.5 billion) on account of redemption of the India Millennium Deposit (IMD) later during the year. The huge government borrowing programme, too, will soak the liquidity.

The inflation rate is likely to remain low on account of last year's high base till the end of the calendar year but eventually it will rise.

These two factors and the robust credit growth may prompt Reddy to consider a small dose of rate hike now. After all, the central bank needs to be pro-active.

It should not wait for the inflation rate to rise. Besides, the finance minister has made it clear that the country would resume the path of "fiscal correction" in the next fiscal year.

For the time being, it will remain "on the pause mode" on restraining the fiscal deficit. When the government is on the "pause mode" on the fiscal front, the central bank may not wish to continue with an accommodative policy to see its market borrowing through.

The most critical argument against the rate hike at this juncture is the growth factor. Reddy may use this excuse for not biting the bullet. If he decides to hide behind the growth curtain now, he may have to opt for a sharper rate hike at a later stage.

Frankly, the governor has no choice. The rates will go up. He may at best delay it by a few months.