Tamal Bandyopadhyay: The interest rate conundrum

The economic recovery in the US will hold the key to interest rate movements in India

In the first week of January, the wholesale price index-based inflation rate climbed to a 35-week high of 6.09 per cent. It had rendered the real interest rates on gilts of all maturities negative.

At that point of time, the yield on 24-year paper due in 2028, was veering at around 6.05 per cent. At the other end, the 91-day treasury bill was trading at 4.25 per cent.

Since then, the wholesale inflation rate has dropped to 4.3 per cent. This, along with the rise in the rupee against the dollar (from Rs 45.25 in mid-March to Rs 43.60 in the first week of April), has fuelled the anticipation of a rate cut in the next annual policy of the Reserve Bank of India (RBI).

The policy will be announced in May, immediately after the results of the general elections are known. But the latest data pertaining to the US economy seems to have toppled the rate-cut bogey.

Before analysing the overheating of the US economy and its impact on the interest rates, let's discuss what fuelled the anticipation of a domestic rate cut in a section of the market.

The trigger was, of course, the sudden rise of the rupee following the rise in inflation. In a way, these two are related. The RBI allowed the Indian unit to rise because this was possibly the most efficient and logical policy response. Although inflation has dropped, it may rise again once the base effect wears off. There are three reasons for this:

• It is cost-pushed through the continued growth in global commodity and energy prices.
• It is demand-pulled through the continued growth in domestic demand "" with a double-digit GDP growth in the third quarter.
• It is also fuelled by the growth in money supply beyond the RBI-projected 14 per cent. This was a fallout of the RBI's dollar mop up from the foreign exchange market.

To check inflation "" as has been pointed out by an investment bank "" there could have been three choices.

First, cuts in custom and excise duties. In response to the rapid increase in steel prices, the custom duty on final steel products and steel inputs have been cut, while export incentives on steel have been frozen temporarily. One can expect more such cuts when the new government places its Budget.

Second, rise in interest rates. An increase in the RBI's bank rate from the current 6 per cent could slow down monetary growth and contain demand-pulled inflation.

However, it would also affect economic growth and could stop the investment recovery. Non-food credit growth in fiscal year 2004 was Rs 1,19,684 crore. There have been tale-tell signs of recovery all around, and any increase in rate could have impacted the pace of industrial recovery.

Third, currency appreciation: it would limit cost-push inflation through its impact on import prices. It would also result in slower accumulation of forex reserves and slower growth in money supply.

The RBI has selected the third option. Although theoretically, exports growth is driven by demand and not by exchange rate adjustments, a strong rupee is bound to upset the exporters' lobby. But RBI has, in fact, a limited choice between allowing the rupee to appreciate and raising the bank rate.

Any increase in rate would have a negative impact on credit growth. On the other hand, currency appreciation would lead to slower growth of foreign exchange reserves and create more space for credit growth.

In an ideal situation, the RBI should follow its policy of staying away from the foreign exchange market, allowing the rupee to appreciate by a rate cut. This is a classical way to ease the pressure on rupee appreciation because this would narrow the interest rate differential in India and the US, and consequently, stall the inflow of dollar.

A cut in interest rates would also have given the new government an ideal pitch to bat on because it would have acted as a stimulus for industrial growth. The double-digit GDP growth in the third quarter was primarily on the account of agricultural growth, but there is no guarantee of a repeat performance this year.

But the latest US data released last week, has dramatically changed the scenario. Until recently, there was a great deal of uncertainty over the strength and sustainability of the US recovery because the limited increase in employment.

The wage growth in the US had suggested that consumption growth is driven by debt accumulation and tax cuts rather than income growth, which may not be sustainable.

But now, everybody knows that the US services sector grew beyond expectations to hit a record high in March. The Institute for Supply Management's non-manufacturing index rose from 60.8 in February to 65.8 in March (the twelfth monthly increase in a row).

Services include everything from restaurants and hotels to banks and airlines, and accounts for about 80 per cent of the US economy. Any number above 50 indicates growth.

The employment index rose to 53.9 in March from 52.7 in February. The growth in demand for new orders rose to 62.8 in March from 60.3 in February.

What more, last week the US Labor Department announced 3,08,000 new non-farm jobs that were added to the nation's payrolls. It is no longer a jobless recovery and the world's biggest economy now looks ready for a strong run.

One must note that the US is not alone in the limelight. A series of surveys of manufacturers worldwide point out that there's more to cheer about. For instance, the Bank of Japan's "Tankan" survey showed that local firms felt better about business in March than at any time in almost seven years.

Further, the dollar gained ground both against the euro and the yen. The yield on benchmark 10-year US treasury also rose to a three-month high of 4.22 per cent. In January, it was veering at around 4 per cent.

Earlier, nobody expected the Federal Reserve to take a look at the interest rate before November. Now it appears that the Fed may be inclined to increase the benchmark US interest rate from a 46-year low of 1 per cent sooner rather than later.

To justify any rate cut move, one might say that the US interest rate hike is still six to nine months away and that the domestic inflation rate has a downward bias now. But the RBI may not be willing to bite the bullet at this juncture.

There was pressure on the central bank in November to cut the rate. It withstood the pressure then. With the US economy shining, and a possible rate increase by the Federal Reserve, the RBI may leave the rates untouched this time too.

An increase in rates can be ruled out because it would bring in more foreign exchange inflows and put pressure on the rupee to appreciate.

This could, in turn, lead to piling of foreign exchange reserves, increase in money supply and ultimately higher inflation. Besides, there will be a political factor too. No new government would like to start its innings with a rise in interest rates.