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Wednesday, Nov 27, 2002

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Low interest rates not spurring new investment

S. Balakrishnan

THE bond rush continues. Yields on the benchmark ten-year Government securities fell as low as 6.4 per cent last week.

With this, they have dropped more than 60 basis points in just three weeks after the mid-term credit policy in end-October when the RBI snipped 25 basis points each off the Bank Rate, repo rate and the CRR. The US Fed's downward move of 50 basis points gave added impetus to prices.

The liquidity overhang persists — unlike earlier, less because the RBI is buying Government securities and more due to the central bank's intervention in forex markets to stem the rise of the rupee. At the same time, remittances are strong, adding to forex reserves and pushing up the rupee, which, in turn, softens interest rates.

Thus, the yield differential between Indian gilts and US Treasuries is as narrow as they have been in perhaps two to three decades. Ten-year Treasuries offer about 4.2 per cent — just 2.2 per cent below that on our gilts. At this rate, as one bond dealer remarked, Indian and US interest rates will soon converge.

It is not that there is no fundamental justification for this to happen. Indian inflation is only 2 per cent or so more than US inflation and if the theory that interest differentials equal inflation differentials is true, there is every reason for domestic yields to settle at the present levels.

Nevertheless, the fact is that US bond yields bottomed a few weeks back. Ten-year bonds, for example, hit a low of 3.6 per cent and have since risen 55 basis points on the back of better economic figures and stock prices. The scope for a sharp rise in medium and long-term interest rates, however, seems limited, given the extremely low level of inflation. As The Economist magazine has pointed out in its latest issue, the most-frequently occurring word in the print media these days is not the dreaded `R' word-recession — but deflation. If indeed, as is likely, this is the case and a recovery is in place, the US will see short-term rates rise more than long, narrowing the spread between the two ends of the yield curve.

What about India? Short-term rates are 4 per cent higher than those in the US. Our yield curve is more or less flat. In contrast to the US, there seems more scope for short rates to fall, especially given the strength of the rupee. Expect, therefore, our yield curve to steepen in the coming months.

From a macro-perspective, while falling inflation and interest rates are good, there is also the feeling of too much of a good thing. Investment is still very slack. Either industry and business cannot justify new investments even at the current low levels of interest rates or banks have not reduced their cost of credit in general to the same extent as the fall in money market interest rates and bond yields, despite the general and sharp fall in the rate of profit in the economy.

An issue worthy of serious research by the Government and RBI?

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