Business

Interest rate signal is the key issue

RBI's challenging task in its mid-term review

ON THE eve of the announcement of the mid-term review of the credit policy, the key issue for speculation in money market circles seems to b whether the Reserve Bank of India will signal a higher interest rate and, if it does, through what means. Anticipating interest rate changes at the time of credit policy announcements has in a sense become nearly as common as guessing income tax proposals befor the Union budget. Quite understandably, interest rate changes today concern practically everyone.

Many of the interest rates are now market determined and hence subject to more frequent changes than when they were administered. But more importantly, with the spread of retail banking, there are plenty more people who borrow to buy a home, for instance. A sizable portion of the furious credit growth recently has taken place in the retail sector, especially in the home loan segment. Evidently those who have to repay their loans over 15 or 20 years will be more attuned to monetary policy changes, especially interest rate revisions.

The sharp increase in the category of borrowers is one reason why monetary policy statements have come to be read and interpreted by wider sections. Depositors too look at the pronouncements but for entirely different reasons. The market orientation given to deposit rates, it is well known, has not served the cause of savers. , For many vulnerable sections such as the pensioners and the retired, interest income from bank deposits is practically the only source. With banks including government owned banks pegging their deposit rates below inflation levels, many depositors are earning negative incomes.

Investors' concern

Outside the prism of the banking system, impending interest rate changes are of interest to retail stock market investors, though not directly. The record corporate earnings in recent years have been possible also because of huge savings effected in interest charges. Stock prices have been boosted by the prospect of corporates continuing to perform well in the second quarter of the current fiscal. (Q2 results are just coming in).

The other connection that stock markets have with the interest rate policy is this. Higher interest rates theoretically attract foreign capital and probably persuade foreign investors to stay on. Very recently foreign institutional investors have turned net sellers. However, it is highly unlikely that the interest rate bait will lure capital into the country in a big way unless, of course, NRI depositors are offered substantially more. Institutional money flowing into Indian stocks is guided by many other considerations besides interest rates.

Main considerations

Taking the external economy as a whole, the classic argument that interest rate policy can be calibrated to support a weakening rupee holds good. But while the rupee has, after a long time, breached the Rs. 45 to the dollar mark, the RBI will not, on this evidence alone, hike the interest rates. The target for the external value of the rupee is unknown. Besides, the widening trade deficit indicates a cheaper rupee in any case.

Traditionally, interest rate changes are dictated by broad macro considerations. A hike is recommended to cool an overheated economy and to check inflation. In the fist quarter, the economy grew by 8.1 per cent — well above the trend rate of 6.9 to 7 per cent. However, there are no supply side constraints as yet. Inflation continues to be a big worry as the pass through effects of the more recent petroleum price hikes have not been fully assimilated. Should the RBI signal higher interest rates tomorrow, one of its justifications would be managing inflation expectations.

High asset values

Another consideration will be based on the fact that asset prices have been inflated already, with the prices of gold, shares and homes at historically high levels. The central bank has already warned against bubbles but it is always a challenge to prevent them. More so when lower interest rates have been equated with investor confidence and when there is an official nudging to keep the rates where they are.

Resurgence of inflation is a concern of many central banks. Since September as many as eight central banks have put up their rates. The U.S. Federal Reserve has done it 11 times in a row.

For the banking system higher interest rates can cause havoc to their balance sheets. Already treasury income earned without significant effort in a period of continuously declining rates is a thing of the past.

Excess liquidity

The RBI last signalled a higher rate in April when it marked up the reverse repo rate (the rate at which it borrows from the market) by 0.25 per cent. That as well as the earlier signal in October 2004 (also through an identical measure) did not make an appreciable impact on interest rates. Excess liquidity has remained. Besides, in an era of competition banks have not been able to resist pressures from corporates to lend at way below PLR rates while depositors get a pittance. Surely this serious imbalance will find a mention in tomorrow's policy statement.

C. R. L. NARASIMHAN

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