The Hindu Business Line : Interest rates should stabilise around current levels

Defending a target interest rate — usually a short-term rate or even a corridor — is the cornerstone of monetary policy implementation by central banks. While this is easily done in mature financial markets, economies (and central banks) transiting to that stage often find it difficult to sustain such a stance for various reasons. These range from the conflict such a sole defence of a target interest rate can cause with the central bank’s other responsibi lities to the financial implications (on the central bank’s balance-sheet) of defending an interest rate.

In the event, money market action by the central bank to guide overall market interest rates becomes more periodical, if not sporadic. Discretionary action on interest rates even by market leaders (leave alone other participants), while it becomes more important in such a scenario, is also more difficult.

Indian financial markets have faced such a situation in recent times. High money market surpluses were not matched by Reserve Bank of India action in defending its interest rate corridor of 6-7.75 per cent. In the circumstances, inter-bank interest rates plunged below 1 per cent and remained around these levels for a considerable amount of time. But commercial banks were also wary of taking the lead in lowering interest rates as a response to the surfeit of liquidity, and were instead looking for a price signal from the central bank.

Preference for stability

By removing the ceiling of Rs 3,000 crore of daily absorption of excess money market liquidity (introduced in March 2007), the RBI, in its Quarterly Review of Monetary Policy, has given such a signal. It has placed a floor of around 6 per cent to short-term interest rates for the time being.

This move, in conjunction with the hike in the cash reserve ratio applicable to commercial banks to 7 per cent from 6.50 per cent currently, should see interest rates stabilise around their current levels. These are broadly around 9 per cent for bank deposits and 11 per cent-plus on the lending side.

No immediate softening (other than those already announced by some banks in their deposit/lending rates) seems around the corner. The Reserve Bank’s preference for the present appears to be continuation of the current levels of key borrowing and lending rates in the system. It possibly feels that the situation is not ripe yet for the high liquidity in the financial system to get reflected in the general level of interest rates.

For good reasons too. While there has been a softening in the wholesale inflation numbers in recent weeks, they still do not appear to have been entrenched firmly. Some volatility also has been noticed in the WPI time series data in recent weeks. Apart from oil, which has been rising ominously, other key commodity prices continue to remain firm both globally and locally.

Pricing power in the domestic manufacturing sector also appears to be holding up despite some softening in the past six months. Primary articles such as wheat, oilseeds, rice, etc., continue to witness double digit price growth, though the good monsoon and upcoming harvests augur well for price moderation on this front. Overall money supply growth in the system is also higher than the levels preferred by the Reserve Bank.

In the circumstances, the RBI appears to have opted for the following policy combination: Active liquidity absorption operations, domestic interest rates broadly around current levels and relatively limited intervention in the foreign exchange market, which should see the rupee strengthening further.

This combination may see the overall level of economic activity — be it investment or consumption — trending down but not to the extent of moving into a recession.

Global cues

Key risks to this outlook appear to arise mainly from the global markets. There has been a sharp re-rating of risk and returns in global credit markets in the past few weeks. Credit spreads for non-sovereigns have widened dramatically on the back of a flight to the safety of US Treasuries (also European sovereign debt). There could be adverse implications for the level of overall economic activity (in the absence of countervailing central bank action) if such “risk aversion” takes hold.

For Indian markets, a slowdown of activity in the advanced countries could mean greater capital inflows, more liquidity, more rupee strength. That may help interest rates move lower sustainably towards the close of the year. On the other hand, there could also be a withdrawal from “risky” emerging markets as part of overall risk aversion. That may see the rupee coming under some pressure and liquidity possibly under some strain. Interest rates may remain broadly stable under that scenario.

More Stories on : Credit Policy | Interest Rates

Article E-Mail :: Comment :: Syndication :: Printer Friendly Page

Stories in this Section
Move to ‘kill’ Kolkata

Coping with the flow

The Kalam legacy

The RBI’s silent signals

A sensible policy, on expected lines

Interest rates should stabilise around current levels

Have success formulas become blasé?

Bio-crop business