The Hindu Business Line : ‘Interest’ing conundrum for RBI

Move over equities, the bond street is in a bull run. The 10-year government bond yield at around 7.8 per cent has moved down 60 bps since its high of 8.4 per cent reached on June 12. The spreads on five-corporate bonds over government bonds have narrowed to around 130-140 bps from around 230 bps. The spread compression witnessed in the last one month has been on increased trading volumes and wider investor participation, a typical characteristic of momentum building up. < /p>

So, is the recent oft-repeated statement true: Have interest rates in India ‘peaked’? The fact that market interest rates have peaked (from its recent highs) is evident from the fall in yields. But interest rate ‘peaking’ in market parlance has to do with whether the central bank is through with its rate hiking cycle or not. The Reserve Bank of India meets on July 31 to communicate its monetary policy stance for the quarter.

Headline inflation, read from the Wholesale Price Index, has been below the 5 per cent RBI target level since May thus warranting no further rate hikes and monetary tightening measures from the RBI. The RBI has been cautious on inflationary expectations and had raised its interest rates and the Cash Reserve Ratio to moderate inflationary pressures. But with a continued reading below 5 per cent, inflation expectations are benign and encouraging for interest rates and thereby bond markets.

Liquidity

From the tight conditions in March, when overnight call rates touched 80 per cent to 0.25 per cent now, there has been a complete transformation in the liquidity situation. Heavy foreign inflows and the consequent need for RBI’s intervention to desist the rupee from appreciating have infused rupee liquidity in the system. Foreign inflows in to equity markets have totalled $8.8 billion since April. Add to that, capital inflows under FDI/private equity/ECB/FCCB and you get the picture.

The credit cycle has clearly slowed. A year back such liquidity would have been easily absorbed by the credit markets but with banks raising interest rates on loans in March, there have been fewer borrowers. Incremental credit disbursals in the first quarter was negative and at the same time high deposit rates have meant higher deposit accretion leading to excess money in the system.

Concurrently, the RBI has refused to absorb more than Rs 3,000 crore at its stated reverse repo rate of 6 per cent in its LAF auction. So any system surplus above Rs 3,000 crore would find its way in the market leading to falling overnight money market rates. This situation has been continuing for more than a month and with banks earning next to nothing on their huge surplus, a part of this money was diverted to buying bonds. The quest for earning higher yields and being able to fund these positions at low rates is a key driver behind the fall in yields and the bullish sentiments. Even mutual funds, ever desirous in maintaining returns on their cash funds, have driven down the yields at the shorter end of the curve.

The RBI has thus far maintained stoic silence leading a nervy market to confront the policy risks with call rates at 0.25 per cent; 1 month rates at 2.0 per cent; 1 year rates at 6.5 per cent. There are as usual varied expectations from the RBI — the cap on reverse repos to be tweaked, the CRR hike to suck out excess liquidity, tighter norms on debt capital flows…

Inflation

True, the current levels do not warrant any monetary action, but upside risks remain from food articles and global metal prices. The NCDEX agri index has inched up 4 per cent since June, probably signifying lower output and higher food prices in coming months. And people seem to have conveniently forgotten about subsidised fuel prices not reflecting high global crude oil prices. With crude oil above $75/barrel, even with the 9 per cent rupee appreciation, the under- recoveries of the oil marketing companies are put at Rs 55,000 crore. Either the government will have to reduce the tax component on oil prices or issue oil bonds and increase the future fiscal cost to foot the bill. Retail fuel price hike looks very much on the cards and can spook inflation.

Credit slowdown

For all of last two years, it was about moderating credit growth. But with year-on-year credit growth slowing to 25 per cent and incremental credit growth negative, the RBI would not want a situation of higher rates impeding credit flows to needy sectors. The RBI has targeted 25 per cent credit growth and 8 per cent GDP growth for financial year 2008 and it would seek to maintain them. The spate of CRR and repo rate hikes till March put severe upward pressure on borrowing and lending rates, leading to slackening credit growth. Banks saddled with higher delinquencies and slower credit growth on one hand and higher cost of incremental deposits are finding it tough to grow profitably. It is about time banks cut deposit and lending rates and boost credit activity. What has stopped them from doing so?

The RBI needs to clearly enunciate its liquidity and monetary policy management.

The cap, we feel, is not a monetary policy signal and is an inevitable outcome in achieving the ‘Impossible Trinity’ — the existence of the cap during periods of high intervention was more of a forex management policy than a monetary policy signal. The RBI chose to simply shift the cost of sterilisation to the market. An unintended (or slightly intended) impact has also been to lower the incremental cost of borrowing for banks giving them the headroom to lower lending rates and still operate profitably. But now the RBI should think of doing away with the cap.

The spike in deposit and lending rates in March was excessive, one that could have threatened the growth potential and which needed to be moderated. And the last two months of low rates has achieved the objective of lowering the term structure of rates and return expectations. The removal of cap would lead to re-alignment of short-term rates but we do not expect a major increase in long-term market yields as the liquidity situation continues to be in excess.

Expectations from the policy

Removal of cap: The RBI might think of introducing variable or long-term repos.

External flows: Some measures on ECB inflows usage on drawdown basis and only for capital imports, overseas acquisitions or repayment of earlier loans. Restrictions on investments of idle/unused funds to prevent arbitrage.

CRR hike: Unlikely. Under normal conditions, such excess liquidity would have warranted a CRR impounding but with credit growth slowing this would prove to be harsh and counterproductive.

More liquidity absorption measures: Might take a provisional hike in MSS limit.

SLR cut: The RBI might look at one more quarter of credit growth patterns and on any signs of slackness, a SLR cut is a possibility. Bond price gains would remain capped on this possibility.

Status quo on interest rates Monetary policy stance: Interest rates may have peaked but we do not believe that the RBI is anywhere near cutting interest rates. The US Fed is a great example. The market expected the Fed to cut rates almost immediately after it paused in its rate hiking cycle. It’s been a year since and still no signs. Central banks would tend to more be cautious in the reversal of policy direction. The RBI has no intention of signalling policy rates downwards but has achieved to lower the trajectory in the last two months. Also of importance would be

Global risk aversion: One key risk to the entire assessment of lower yields, adequate liquidity and strong rupee is an increase in global risk aversion. It could manifest from US sub-prime woes, weakening US economy, fallout of LBO deals, US treasury and credit markets, China’s economy…but wherever it comes from the impact would be felt across the globe. That is the price to pay for financial integration.

(The author is a Fund Manager — Fixed Income — at Quantum AMC. He can be contacted at Arvind@QuantumAMC.com)

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