The Hindu Business Line : Will interest rates rise?

A rise in foreign rates could be a matter of concern to India as it may lead to drying up of the inflow of funds unless countervailing action is taken.

THE recent hike in interest rates in the UK and Australia has raised speculation about a possible rise in India too. It is possible that the US may follow suit before long if the momentum of growth recorded there for the latest quarter is maintained and is also accompanied by emerging signs of inflation. However, the rates are not likely to go up in India for quite some time for the following reasons.

In the first place, as the Reserve Bank of India (RBI) has pointed out, the possible rise in interest rates abroad was taken into account in the latest Monetary Policy Review. In other words, the central bank felt that no change in domestic rates was called for, at least for the time being, even if they rose abroad. It is a measure of the globalisation of the Indian financial system that such issues are now discussed.

A rise in foreign rates could be a matter of concern to the country as it may lead to drying up of the funds flow unless countervailing action is taken. But, today, the authorities are facing a problem of plenty in forex reserves and are coming out with measures to stem the tide. Apart from the losses that may occur because of the low return on the reserves invested abroad, there is a question of impounding them, lest they damage projections on money supply and inflation.

The RBI's stock of government securities is fast depleting due to its Open Market Operations. Before long, it may have to think of an alternative instrument like the issue of its own securities. Otherwise, it will have to raise the Cash Reserve Ratio (CRR). In fact, in the latest Report on Trend and Progress of Banking in India 2002-03, the RBI issued a veiled warning that it would not hesitate to raise the CRR, if required by macroeconomic factors. Under the circumstances, a slowdown in the inflow of foreign funds will be a welcome breather to the central bank.

There is, of course, the possibility of foreign capital flowing out. However, that may not happen at one go because much of the deposits of non-resident Indians are of a medium-term nature. They may be repatriated as and when they mature. Otherwise, the depositors may have to pay penalties, which may not be worthwhile. Thus, it would give authorities time to monitor the trends and take corrective action. Of course, during the Gulf crisis in the early 1990s, there was a severe haemorrhaging of forex reserves due to repatriation of funds by NRIs. Of course, the situation was different then. Indian banks were, then, offering NRIs as high as 2 per cent above the Libor. There was also exchange rate guarantee for rupee deposits.

NRIs, particularly those in the Gulf region, were known to have borrowed from non-Indian banks to take advantage of the arbitrage opportunity, and opened deposits in India. Once the country got into trouble, the banks pressured the borrowers to return the loans. They, in turn, had to repatriate their deposits from India. Now, if the inflow slows down, the appreciation of the rupee may halt and there may be even depreciation. This, in turn, will make it unattractive to repatriate rupee funds in NRI deposits as there is no exchange guarantee now. A halt in appreciation or the possibility of depreciation would be welcome to exporters.

The Thai example of losing reserves in the East Asian Crisis during not applicable because there is no fixed exchange rate to defend.

Critics of the low interest rate policy have pointed out that it may lead to a reduction in savings. So far, the trends in financial savings have disproved this hypothesis. The Government's Small Savings Schemes continue to be popular with the public as also the Drought Relief Bonds, both taxable and tax-free types. Those who talk about the influence of the interest rate on savings should take note of the special characteristics of Indian society. In the first place, there is the question of saving for the rainy day. The average man in the developed countries has access to social security measures to take care of unemployment, sickness and old age. These facilities are, by and large, absent in India.

Again, there is the ethos of a man saving and leaving property for children. In the West, this attitude is absent since the basic philosophy there is that children, once grown up, should fend for themselves. That is how in their wills many gift away their properties to charities. Once in a while, one even comes across the phenomenon of the properties being left to care for after the death of their owners.

Thus, the Indian context for saving is totally different. The common man will save, regardless of the interest rate. Did not people save in the past when there were no financial institutions to mobilise their savings? They buried their savings or in gold with zero return except perhaps for the few who engaged in money lending. Income decides the level of saving, while the interest rate determines its allocation among various investment avenues.

Recent studies of company's finances show that about a half of their increased profitability was the result of the reduction in interest rates. Given their compulsions arising from the problem of non-performing assets, banks may have to raise their lending rates if they are forced to hike their deposit rates. It is a fact that while banks are prompt in lowering deposit rates when there is a change in the RBI's policy, they are not so in respect of lending rates.

There is a certain asymmetry here. In other words, if banks raise deposit rates they will simultaneously increase lending rates also. At a time when there are signs of revival of the economy, the policy-makers may not find it desirable to envisage such a scenario. Further, as of now, the price trends are benign and the central bank has predicted an inflation rate of 4.5-5 per cent with a downward bias.

Many banks have improved their bottomline in recent years due to profits made in treasury operations as a result of the rising securities market caused by the fall in interest rates.

The provision for loss in the value of holdings in case of a rise in interest rates is not adequate to cover the full risk. The central bank may not be guided by the impact of the interest rate rise on the banks' portfolio in taking a decision for formulating the monetary policy. But it may have to reckon with the factor.

Recently , there was a strange statement from a former Unit Trust of India Chairman, blaming the RBI's monetary policy for the mutual fund's woes. The central bank cannot formulate policies keeping the interests of individual institutions in view. But in the case of banks, it is dealing with a system.

(The author is a former officer-in-charge of the Department of Economic Analysis and Policy, RBI.)

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