The Hindu Business Line : Interest rates set to harden

It is unlikely that the Government can fulfill its promises of huge investments in the rural and the manufacturing sector without straining its finances.

A 2.5-lakh odd growth in jobs last month in the US has almost made it certain that the Fed shall hike rates by at least a quarter percentage point in their next meeting, which is scheduled on June 29-30.

I personally think that you could see the Fed hike rates by almost a full percentage point over the next six to nine months. Four 25 basis points hikes in six to nine months is not steep as even after these, the Fed funds rate would reach only two per cent which is still much lower than the consensus neutral Fed funds rate of almost 3-3.50 per cent. In other words, a 100 basis point hike over six to nine months will qualify as `measured'.

Over the last few years, our domestic financial markets have become more and more integrated with the international markets.

I clearly remember that a few years back, the Indian bond market would not even yawn at the overnight volatility in the US interest rate market whereas the other Asian bond markets would almost have a one-on-one reaction.

On innumerable occasions, we would buy or sell bonds based on interest rate developments overseas and invariably lose money. That has changed now as we see the interlinkages getting more and more pronounced.

The change of guard at the Centre is also not helping the case for any further reduction in domestic rates.

The Government survives on the crucial support of the Left parties and I have no doubt in my mind that the Congress would not even think of touching the sensitive issues of a reduction in the small savings rate or the EPF rate.

As we all know that the rate of interest paid by the Government on the special deposits of the PFs was reduced to eight per cent last year with the other small savings schemes. But the Central Board of Trustees agreed to pay 9.5 per cent on the EPF for 2003-04 by nibbling into their reserves.

One thought that may be from this year the EPF rate would also fall in line with the other small savings rates as EPF reserves are not unlimited.

But given that all the trade unions met the Finance Minister on Saturday demanding an increase in the EPF rate to 12 per cent, I think the best he can do in the current environment of reforms with a human face is maintain the rate at 9.5 per cent with eventual budgetary support.

Mr Chidambaram used to write for the Indian Express. I still have a copy of one of his columns where he had argued that a mindless reduction in rates was hurting the savers hard and a balance of some kind was required.

On his last trip to Mumbai a couple of days back, he has reportedly asked the RBI Governor, Dr Reddy, to `not raise domestic rates till such time that the international rates do not come close to the level of Indian interest rates'.

Even the RBI has, in a subtle manner, removed the soft rate bias from its official monetary policy stance that it presented last month. In the current environment, it looks like the next move of the RBI on interest rates will be up, rather down.

The FDI component in the planned privatisation of the Delhi and Mumbai airports has already been slashed from 74 per cent to 49 per cent.

Given that you see photos of high profile Left party leaders sitting on dharnas with the airport unions protesting against their privatisation, one wonders if the Congress will ever be able to muster enough political will to privatise them at all.

Today's (Sunday) newspapers carry reports about Lalu Prasad saying that he will not permit any privatisation in the railways. I mean we are kidding ourselves if we believe that this Government will have the political will of going ahead with privatisation of any sort, at least for the next one year.

So where will it garner the resources for the huge investment plans it has for the rural sector?

The Finance Minister seems committed to fiscal prudence but the mathematics somehow doesn't add up. It is unlikely that the Government can fulfil its promises of huge investments in the rural and the manufacturing sector without straining its finances.

In this background, we could see the one over 10-year sovereign spread start widening.

We could see the 10-year yield move up to 5.50 per cent over the next couple of months and to 6 per cent by the end of the year.

(The author is a senior trader, interest rates at HSBC Mumbai. The views expressed herein are his own and not necessarily those of his employer.)

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