The Hindu Business Line : CRR hike in offing?

BONDS have rallied over the last couple of months. The 10-year sovereign yield is close to 5.05 per cent, the 10 cross 20-year spread has shrunk to almost 60 basis points.

There seems to be limited upside from here, it looks unlikely that the 10-year yield will pierce the 5 per cent level without solid rate cut expectations in the forthcoming policy. But to my mind, even the downside looks limited.

A cursory look at the economic fundamentals may seem to point at a reversal of sorts in interest rates, but a closer look will tell you that a reversal is still far away. All the economic numbers are strong, be it the IIP or the GDP or the infrastructure index. The table alongside shows that even the non-food credit has picked up smartly in the second half of the last financial year. It is up some 32 per cent over last year.

Yields in the US have shot up by almost a hundred basis points from the lows that we saw a few days before the last payroll report. The payroll data, the CPI, the industrial production and now the durable goods, all of these numbers have been much stronger than expected.

Though Mr Greenspan has said that he believes that the threat of inflation is several months away, in ways more than one he has prepared the market for rate hikes sometime in the future. Combine this with the level of economic activity here in India and a rate reversal looks imminent.

I have tried to look at the expected economic numbers for the next three months and the reversal story does not look credible yet. Agreed that the non-food credit has picked up over the last six months. But the increase in money supply has been sharper, by almost 54 per cent in the same period.

Thanks to the staggering increase in the forex reserves of the central bank in the last couple of weeks, the money supply-credit pickup differential is only going to widen over the next three months.

And given the existing liquidity situation, credit pick-up by itself is not going to push up rates for sure.

The inflationary outlook also does not look bleak over the next three months, provided the monsoon does not disappoint. With the exception of 2002-03, inflation has grown at almost 4.50 per cent in the April-June quarter in the last three years. 2002-03 saw an 8.65 per cent annualised growth in this period because primary article prices rose very sharply on account of poor monsoon. The primary articles component rose by almost 12 per cent in this period.

Even if you assume a 6 per cent growth in the wholesale prices in the April-June quarter this year, the year-on-year headline number will still be 4.94 per cent at the end of the quarter. So it is unlikely that inflation will cause much worry to the central bank for it to change its policy objectives.

The average net Central Government borrowing in the first quarter of each of the last three financial years has been close to Rs 40,000 crore.

Excluding the April auction that has been already cancelled the RBI auction calendar shows a gross borrowing of Rs 28,000 crore in the first quarter of this year. If you remove the maturity amount of Rs 23,277 crore, the net borrowing this quarter is a meagre Rs 4,723 crore. Compare this to the average of Rs 40,000 crore, it is unlikely that the Government's borrowing schedule will put any pressure on rates. In fact, the frugal issuance can cause spreads to shrink further.

In the absence of any RBI action, interest rates should move in a 10 basis point range over the next couple of months. The RBI action can only be in the form of lowering rates if at all. In fact, there seems to be some genuine concerns about the mounting costs of the central bank intervention and the sterilisation that goes on with it. I will not be surprised to see the central bank hike CRR and cut the repo rate simultaneously in the forthcoming policy.

A CRR hike looks probable only because the forex inflows are just too huge, they cannot be sterilised through MSBs alone.To sum it up, in the face of an appreciating rupee and such huge forex inflows, it is unlikely that the rates can go significantly higher.

(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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