Tamal Bandyopadhyay: King Canute and the rising interest rates

Finance Minister P Chidambaram's moral suasion to stop banks from raising the lending rates will not work. The rates will rise, no matter what.

What do a bank branch and a petrol pump have in common? Given a choice, both will sell their products at a price much higher than what they charge their customers now.

The petroleum ministry has so far not allowed oil companies to pass on the burden of higher global prices to their domestic customers. Now, the finance ministry seems to be following the same path. It is not willing to allow banks to raise their lending rates even though the market rates have been going up.

Except for small loans up to Rs 2 lakh and certain categories of export credit, all loan rates have been freed. But the finance ministry wants to turn the wheel and go back to the administered rate raj.

Former Finance Minister Jaswant Singh wanted the public sector banks to lend to the agriculture sector at an interest rate determined by the ministry. P Chidambaram, however, is not prescribing any rate. He is merely suggesting that the loan rates should not go up.

Within hours of Reserve Bank of India (RBI) Governor Y V Reddy raising the short-term reverse repo rate by 25 basis points (one basis point is one-hundredth of a percentage point) at the central bank's annual policy last week, Chidambaram issued a statement saying, "I do not think an increase in the reverse repo rate will affect lending rates. There is enough liquidity in the market. Therefore, lending rates will be benign."

Technically, it is "moral suasion" "" an application of indirect pressure, but not force, by an authority to get the players in a particular field to adhere to a policy. This is also known as jawboning.

For the time being, Chidambaram has succeeded. Or, has he? Bankers across the board, after hearing him on TV, made a point to say there was no case for a rate hike. But that was their official stance.

Unofficially, off the record, most of them admitted that they are left with no choice but to raise their lending rates, because otherwise their net interest margin "" the spread between the cost of raising funds and the earning on deployment of the funds "" will be under pressure.

The yield on the 10-year benchmark 7.38 per cent 2015 paper moved up from 7.11 per cent before the policy announcement to close the day at 7.23 per cent. The actively traded 8.07 per cent 2017 bond also moved northwards to close the day at 7.53 per cent. At the shorter end, the one-year 11.68 per cent 2006 bond moved up by 24 basis points to close the day at 5.88 per cent. The market absorbed the shock of a rate hike without much fuss.

Now, most of the bond houses have been saying that the 10-year paper yield would rise further. While JP Morgan Securities India Pvt Ltd expects the 10-year paper yield to touch 8 per cent by December 2005, Barclays Capital, the investment banking division of Barclays Bank, projects it at 7.60 per cent by the year-end and ICICI Securities at 7.50 to 8 per cent by March 2006.

They also feel that it is only the beginning of a higher interest rate cycle and the reverse repo rate may climb up to 5.50 to 5.75 per cent by the end of the fiscal year.

JP Morgan Securities feels that the RBI could hike the reverse repo rate by 25 basis points in the July and October reviews, pushing the policy rate to 5.5 per cent by the end of 2005. Barclays anticipates another 50 basis points hike in the rates by end of 2005 and ICICI Securities expects the rate to rise to 5.50 to 5.75 per cent by March-end.

So, bankers are preparing for a hike in lending rates despite Chidambaram's moral suasion. They will not, however, hike the rack rates of deposits immediately. Here, the rates will be jacked up on a case-by-case basis, depending on the size of the deposit and the negotiation skill of the depositor.

For instance, a very large public sector bank has recently offered a 7 per cent interest rate on a one-year deposit to a corporation while the official rate card cites 5.75 per cent as the interest rate. This is the most economic way to raise rates, because otherwise banks will end up paying much more if they go for a hike in rack rates.

Similarly, in the case of lending rates, there will not be any change in banks' prime lending rate (PLR) "" the rate at which theoretically the best borrowers raise money from financial intermediaries. However, the spread below the PLR will contract. In other words, the sub-PLR borrowers will have to cough up more for every rupee they raise from banks.

In October, 1994, the RBI gave freedom to banks to fix the rates on all loans above Rs 2 lakh and introduced the concept of PLR. However, since banks were initially charging a very high spread over PLR (over 4 per cent), since October 1996, they were directed to announce maximum spread over PLR for all advances other than consumer credit, after approval from their boards.

In 2000-01 the concept of tenure-linked PLR was introduced to give banks more operational flexibility and the very next year the RBI made PLR a benchmark rate allowing banks to lend at below the PLR.

At the moment, over 60 per cent of the borrowers raise loans at below the PLR. This number is rising by the day. However, the spread below the PLR is shrinking. Since banks are not encouraged to raise their rates openly, they are doing so by stealth.

So, a customer who could raise money at 3 percentage points below the PLR before the policy announcement will be asked to pay 2 percentage points less than PLR today. For all practical purposes, PLR has become an academic exercise and banks are raising their lending rates quietly without inviting Chidambaram's attention.

Officially, PLRs will be raised when there is a hike in bank rate (or repo rate), which is now ruling at its three-decade-old low of 6 per cent. Reserve repo is a mechanism through which the central bank sucks out liquidity from the system while repo is a liquidity injection facility and bank rate is the rate at which the RBI offers refinance to commercial banks.

In a liquidity surplus situation, the rate at which liquidity is sucked out or the reverse repo rate controls the interest rate architecture. The repo rate and the bank rate play the same role when the liquidity is tight.

Since liquidity continues to be easy, Reddy is expected to use the lever of reverse repo rate for the time being. One can expect banks to raise their lending rates slowly but steadily cutting the spread below the PLR. Once the repo rate or bank rate is raised, they will officially raise their PLRs.

Even at that time if Chidambaram wants the rates to not rise, he may end up playing the role of King Canute of England. He may yell at the interest rate waves saying, "I command you to come no further! Rate waves, stop your rolling! Do not dare to touch the Indian economy!" He can even go further and shout: "How dare you! I have ordered you to retreat before me, and now you must obey! Go back!"

But the interest rates will only rise further. It is another matter that the growth momentum may continue despite the rate rise as India Inc has acquired the resilience to live with a situation when rates are no longer benign.