The economy, consumer and business can clearly withstand a rate hike and the Governor will inevitably take the cue.

S. Balakrishnan

Not often does the Governor of a central bank have the luxury of a clear-cut decision on interest rates. For the RBI chief, Dr Y.V. Reddy, this is one such time, as he positions himself to announce the monetary and credit policy for the second half of 2006-07.

The data - statistical (GDP growth is near double digits), anecdotal and visual - are quite unambiguous. The Indian consumer is on a spending spree and India Inc is in the midst of an investment boom. These are reflected in the spectacular half-yearly financial results of the corporate sector.

Return on capital tops 20 per cent and in many cases is in the region of 30-40 per cent - well above the cost of capital on any risk-adjusted basis. That profit rates are so high in today's competitive markets when shortages are history is obviously because demand is very buoyant and market size is expanding rapidly. Price discounting and special offers have become a permanent feature of the landscape, but do not seem to have dented corporate profits much.

Bank credit expansion has outpaced deposit growth and is being fuelled by strong consumption and investment. Tomorrow's income is being consumed today as optimism about the future and financial intermediation grows.

Exports are on an upswing as are portfolio inflows, but forex reserves continue to hover around $165 billion. We should, of course, be thankful that reserves have not been drawn down despite the big run-up in the price of oil.

Still, we are far from China's league. Huge trade surpluses and much larger foreign investments have driven its reserves to $1 trillion - easily the largest in the world. The difference is clearly in manufacturing, where we are well behind but improving fast. Together with the quality and productivity revolution under way, increasing `hard' (as opposed to `soft') exports will, in time, make our forex balance sheet asset-intensive like China's.

The key determinant of the RBI's stance on interest rates, as always, will be inflation, its outlook and expectations. Here, the portents do not support the case for no change. Inflation is well over 5 per cent and unlikely to come down, given demand pressures. On the supply side, the global prices of agricultural commodities are rising sharply, following crop failures and new uses, e.g., corn for fuel.

The economy, consumer and business can clearly withstand a rate hike and the Governor will inevitably take the cue.

The situation on the liquidity front in the coming months is not likely to be sanguine. Thanks to the (misplaced?) concern about the fiscal deficit, the government will pull the plug on spending ahead of the Budget and hoard cash with the RBI.

This need has become more acute, given its unwillingness (or inability) to increase fuel prices and the obligation to compensate oil companies for their losses. The hope must be that the axe does not fall heavily on worthy expenditure. Thus, the market must depend on the central bank's repo funds and its (uncertain) dollar buying in the forex market for the supply of primary liquidity.

What will be the fallout on bonds? Tightening market liquidity and a shrinking differential between bond yields and money rates should see 10-year yields hardening significantly to 8+ per cent levels, post-monetary policy and in the coming months.

(This article was published in the Business Line print edition dated October 31, 2006)
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