The Hindu Business Line : On rising trend

If the economy is to keep up with other countries in a deregulated milieu, it has to adopt the interest cycle of the global economy, which seems to be moving up.

The liquidity overhang, which was prevailing in the Indian economy so long, is under pressure. The country's liquidity has run dry mainly because of (a) the robust credit growth compared to deposit, (b) the outflow on account of India Millennium Deposit redemption, and (c) the reduction in foreign currency accretion with the Reserve Bank of India.

Against the backdrop of a severe liquidity crisis, higher inflationary expectation — on account of probable hikes in oil prices and higher than expected money supply growth — the RBI in its latest Credit Policy hiked the reverse repo rate for the second time running.

The question is if the market will sustain itself against a rising trend of interest rate and for how long.

What influences rates

Several factors can influence a rising trend in interest rates. In an open economy the domestic interest rate is influenced by international rates, which in this case has been on the upswing since 2004. In the light of this, India's interest rate should go up in the medium term.

A higher interest rate will benefit the country as it will attract more foreign capital. On the other hand, lack of sufficient interest rate differential between the domestic and international economy could result in an outflow of portfolio investments, put pressure on domestic interest rates as also the rupee. A higher interest rate may be needed to control the anticipated higher inflation. Though India's inflation rate is under 5 per cent, it may move up on account of cost-push and demand-pull factors.

Demand-pull inflation

Higher commodity prices, enhanced industrial growth and economic activity may lead to demand-pull inflation. Also, the average salary hike in India — according to the latest survey of an international manpower agency — will be comparatively steep at around 14 per cent in 2006.

This will create demand-pull inflation pushing up production cost, leading to cost-push inflation.

The monetary policy reverse repo rate hike can be justified in the backdrop of a higher than expected monetary growth, robust credit expansion and higher asset prices. A hike in rate will not only curtail the disproportionate credit growth but also bring credit discipline.

However, rising interest rate may affect the momentum of credit offtake. Then again, it has been repeatedly shown that in India investment and industrial growth are not very interest rate sensitive.

This is because credit offtake depends more on effective investment demand, better investment climate, improved business confidence, higher corporate growth and, of course, strong economy fundamentals. These factors are favourable in the economy now.

With indications of a further hike in the US and the European Central Bank's interest rates, it is more likely that India will follow suit. Because if India's economic growth is to keep up with that of other countries in a deregulated market environment, it has to adopt the interest cycle of the global economy.

(The author is Assistant General Manager, Corporate Strategy and Planning Department, IDBI, Mumbai.)

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