The Hindu : Business : Preparing the market for a higher interest rate

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Saturday, Jul 03, 2004

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Business

Preparing the market for a higher interest rate

By C. R. L. Narasimhan

The RBI Governor's interview to this newspaper has been interpreted as the first hint of a harder monetary stance. Preparing the market for a change in interest rate is a crucial task.

The Reserve Bank of India Governor, Y. V. Reddy's recent interview to The Hindu (published on June 21) has widely been interpreted as a hint of a dearer monetary policy. Dr. Reddy talked of revisiting domestic rates if global rates harden. Subsequently released inflation figures and the hike in the benchmark interest rates by the U.S. Federal Reserve (on June 30) have convinced many analysts of an inevitability of a higher interest rates in India. The question is not whether but when the RBI will signal a change reversing what seemed not very long ago as an "irreversible'' trend. Dr. Reddy's message may well have been aimed at preparing the markets for the interest rate increase. Looking at bond markets' behaviour last week, that message seems to have definitely gone home. Until now fanciful expectations have been raised: that interest rates could only go lower and that there is in fact no such thing as an interest rate cycle in this country.

Politicians, among others have been responsible for a mindset that will not countenance an interest rate hike. Bank borrowers represented by various industry associations have been clamouring for still lower interest rates. Exporters especially have been in the forefront, claiming that cheaper funds (through lower interest rates) are a must to stay competitive. Their other requirement — of a cheaper rupee (in relation to the dollar) — has somehow lost its original appeal.

Exports have, overcoming the dire prognosis of experts, actually fared well in the face of a continuously appreciating rupee over a fairly long period over the past year. The point here is there will always be two sides to any change in a macroeconomic variable so fundamental as interest rates. In India unfortunately the genuine concerns of those affected by the significant declines in interest rates have not been heard leave alone acted upon. Nor is an appreciating rupee always `harmful' to the macro economy.

Imports, especially oil imports were paid for with fewer dollars. A softer interest rate regime does favour many sections of the society. As banks lowered their benchmark lending rates by more than 4 to 5 points, borrowers saved enormously in interest costs over the past few years. The Government could complete its borrowing programme at minimum costs. The biggest beneficiaries, however, have been the numerous retail borrowers who could acquire all types of assets including homes (many for the first time). The exceptionally low interest rates on loans offered by the ever willing bankers have made it possible. Banks as a class too reaped the advantages of a falling interest rate regime. Their holdings of bonds and other fixed income securities resulted in bonanza. As interest rates fell continuously the value of holdings grew. Many of them booked profits by selling the vastly appreciated securities.

Those who have benefited from the soft interest rate regime will now have to reconcile to a situation where the rates can only go up. There have been several indications already of an imminent interest rate hike and the consequent ushering in of dearer money. Banks and hosing finance companies that were offering loans at fixed and variable interest rate basis are now withdrawing the fixed option. Floating rates on housing and other long period loans appear favourable to the borrowers initially. But those who were advised properly could lock in their interest costs over a long period of time. Now that the option seems to have been lost.

There are also reports of corporates trying to firm up their interest costs of long-duration loans. Evidently the risk premium on these is set to move up. There are other indications as well. The changed political situation is one factor. As the recent controversy over the Employee's Provident Fund contribution shows, it will not be politically feasible to lower the yield on these from the existing 9.5 per cent level even if the market interest rates are nowhere near that. There is a high possibility that the budget will throw light on some new schemes, that have already been contemplated, to protect the retired and others who have suffered from the low interest rate regime.

A scheme carrying an above market yield targeted at the vulnerable sections looks certain to be launched, perhaps as early as next week's budget. Besides, it is unlikely that the Government will move to lower the administered interest rates on post office savings, PPF and so on. Those would have been difficult decisions at any time, even when there was a bias towards softer interest rates. In times like the present, with interest rates set to harden on top of a mounting inflation, they would be politically unacceptable.

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