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Interest rates: What next? - Views on News from Equitymaster
 
 
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  • Oct 19, 2004

    Interest rates: What next?

    The monetary policy is upon us again and this being October, points to the beginning of the busy season. Without delving much in to the importance of the monetary policy statement, we would like to point out that this busy season monetary policy statement assumes high significance. This monetary policy would highlight whether the RBI is able to counter various domestic as well as international pressures and still keep interest rates at current levels.

    There is speculation among market participants that the RBI is likely to hike interest rates, at least initially in the short-term, in the form of a hike in the repo rates. There are various factors that are likely to influence the RBI's decision with regards to its position on interest rates. One of the foremost factors is that of inflation and the recent trends on the same are anything but encouraging. While the inflation rate (measured on the wholesale price index) has shown signs of softening (from a high of over 8.0%, the rate has settled to just below 7.5%), we would like to point out that since global crude prices are not showing any signs of softening and that the government has not resorted to price hike of petroleum products, the effect of higher crude prices have not exactly been factored into inflation, as measured at the consumers' level.

    While this is likely to have an adverse impact on the financials of Indian oil marketing companies, the government has been able to stem inflation to an extent. The government has also tried to act of the fringe by hiking the Cash Reserve Ratio to 5% (4.5% earlier), which has sucked excess liquidity and in turn has helped tone down inflation. As inflation remains a threat, it remains to be seen how the RBI deals with the same when formulating its monetary policy statement.

    Another factor that may indirectly impact interest rates is the RBI's recent move to allow banks to transfer their G-Secs in to the HTM (Held Till Maturity) category (essentially to reduce banks' losses on the G-Sec portfolio). This move is likely to take a toll on the liquidity of these G-Secs as the HTM category warrants that the banks hold these securities till maturity. This may put upward pressure on G-Sec yields due to lack of proper price discovery. This aspect was highlighted by the chairman of one of the prominent private sector banks in the country.

    Now, there is likely to be pressure from another quarter - on account of increased credit offtake by Indian corporates. While there is still surplus liquidity in the system, a large-scale offtake of credit would immediately suck up this excess liquidity and this would put direct pressure on interest rates. Unlike China, India does not have huge FDI inflows that can help meet the demand for capital, neither does it have a high savings rate (nearly 40% for China and 25% for India) to meet the demand internally. In such a scenario, the Indian economy may be susceptible to a spike in interest rates (possibly a short-term phenomenon).

    Conclusion
    In the overall analysis, RBI's task is clearly cut out. While it was a different story when the economy was witnessing a low inflation scenario, the current environment is different at present and we may see some initiatives by the RBI with regards to interest rates at least from the short-term perspective. Neither the government nor the RBI could afford to retard the investment climate in the country and thus the long-term objective would ideally be to keep interest rates low.

    In the long-term, however, fiscal policy plays a more important role and it remains to be seen how the government is able to keep interest rates under check especially when it has planned a slew of populist measures (like the employment guarantee scheme, free electricity for farmers and financial support of Rs 163 bn for central PSUs). Investors need to gear up for a possible rise in interest rates (at least in the short-term) and consequently investment decisions have to keep this aspect in mind.

     

     

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