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Economy: Interest rate conundrum...

Jul 27, 2006

The central bank's move of taking the reverse repo rate to a four-year high of 6% is being largely comprehended as a defensive move, before the WPI figures exceed the central bank's comfort zone of 5% to 5.5%. An analysis of the liquidity situation in the economy, consumer prices and economic growth numbers, however, contradict this view.WPI - Not an accurate measure of inflation
The commonly used Wholesale Price Index (WPI) inflation indicator in India is similar to the Producer Price Index in other countries. Hence, India's WPI inflation rate has been extremely sensitive to wholesale commodity prices and not necessarily representative of underlying final consumer goods prices. Moreover, WPI is also biased towards goods prices and offers very little representation of services and prices at the consumer's level, thus giving a wrongful impression of the real inflationary scenario in the economy.

Liquidity - not abundant enough!
The RBI, in its monetary policy review, has given a caveat of negative surprises emanating in the near term, if the unwarranted exceptional growth in credit disbursement continues. This is despite the higher provisioning having been accorded to high-risk asset classes. This has also been accorded to the surplus liquidity present in the system. However, the credit growth seems well justified when compared to the real GDP growth. Also, the growth numbers for money supply and deposit mobilisation (largely term deposits - due to fiscal benefits) speak for themselves.

(%, YoY)1QFY061QFY07
Real GDP growth8.6 9.3
Inflation (WPI)4.1 4.7
Crude oil prices (US$ / barrel)58.1 71.4
Growth in money supply (M3)13.8 18.8
Aggregate deposit growth14.9 20.7
Non food credit growth31.0 32.9
Export growth (in US$ terms)35.4 16.9

While the Reserve Bank of India (RBI) deems the interest hikes to be pertinent, to contain a superfluous liquidity expansion, a comparison with the trend seen in corresponding quarter of FY06, shows that the spurt seen in 1QFY07 is pretty seasonal. Infact, excessive tightening may lead to burgeoning interest burden in the books of the corporate and retail borrowers, leading to the creation of bad assets.

Falling in line with global peers?
A comparison of the short term interest rates in the country, vis-a-vis its peers in the developed and developing world, shows that the RBI is largely trying to align the economy with the global trends. The bank has also indicated that with the balance of risks in the previous fiscal being tilted towards the global factors, and in a situation of generalised tightening of monetary policy, India cannot afford to stay out of step.

We believe that debt-funded consumption growth, which has been at the heart of the GDP growth trend over the past three years (non food credit to GDP has grown from 50% in FY03 to 80% in FY06), may be hit by the rise in the cost of capital and lead to the consequent soft landing of the credit growth cycle. Further, India is now running a current account deficit (13% of GDP) that is funded to a large extent through less stable capital inflows, influenced by global risk appetite and the US interest rate cycle. Hence, we believe that, incrementally, the RBI will hike its short-term policy rate in line with the Fed rate.

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