No rate raise, for now

Moses Harding, executive VP (treasury & investment banking) & international division, IndusInd Bank

It is always difficult to face the realities of 'change'. The markets are no different. Having enjoyed the fruits of the declining interest rates for the past three years (2001 to March 2004), we have already seen a good turnaround.

The 10-year benchmark yield has moved from 4.9 per cent (seen just ahead of October 2003 monetary policy) to close to 7 per cent seen recently.

It is indeed volatile both on the interest and exchange rate front. Historically, the Indian forex and money market movements have been inter-dependent.

Now, with most banks having shifted 100 per cent of their SLR portfolio securities to the held-to-maturity category, the direction of interest rates in the coming months or years may not be of great interest to commercial banks. Moreover, higher rates means better net interest income.

At the top of the agenda is the rising inflation and negative inflation adjusted return for the depositor or investor. This upsurge in inflation is attributed to external factors, which are demand-pull and cost-push in nature mainly on higher oil and commodity prices.

I do not see a reversal immediately in the short term, although it may not be sustainable in the long term. Hopefully, oil and commodity prices should be back to realistic levels to remove the cost-push factor.

Hence, the outlook on inflation is not too positive in the short run, to stay within 7-8 per cent, while in the long run it should head towards 5.5-6 per cent. Hence, one may not be surprised to see rates heading north in the short term. But things should turn for the better in the long run.

Liquidity is not a major issue in the short term with supply outweighing demand. However, credit pick-up should bridge this gap to put pressure on rates.

We have already seen demand for rupee credit shift from foreign currency, which was hitherto in demand, with good credit growth across banks. I do not have any doubt that the central bank would ensure adequate liquidity to support the growth of the economy, through adequate monetary measures.

The factor that is in very much favour of stable to easy interest rates in the short/medium term is the movement of global rates. While domestic rates moved up by over 170 basis points (in the 10-year benchmark government security yield), global rates have moved lower by 50-70 basis points across the board.

This highlights the fact that the recent moves are not purely fundamental in nature and more of position adjustments by market participants, especially banks which had to trim excess holdings to guard against depreciation of their investment portfolio.

Interest rates will be in a consolidation phase in the short term, in a correction phase in the medium term (moving lower) and stable in the long term.

Corporates need not worry too much on their interest cost and it would be a great opportunity for investors to absorb high-yield bonds for definite short-term gains.

I would not be surprised to see 10-year gilt yield going below 6.5 per cent to settle around more realistic levels of 6.0-6.25 per cent. Possibly, a 'no-change' stance on October 26 should be the trigger.

Case for a hike building up

R V S Sridhar, chief dealer, UTI Bank

Companies and banks are looking forward to the Reserve Bank of India's mid-term annual policy review, to be announced later this month, with trepidation.

It seems there is a much better consensus today than six months ago on the direction interest rates could take in the short and medium terms.

Some confusion has set in on the interest rate front, of late, as a result of the apparent disconnect between the statements from the RBI and the Central government. However, this could be owing to the difficulty the policy makers are facing in making the tough decision.

On one hand, we have the inflation rate moving up. On the other, credit offtake is beginning to happen finally. A tight rate policy may be seen as a medicine for the first but may slow down asset creation in the economy. With the government focused on carrying the country on to a higher growth plane, investment demand seems to be rising.

Over the last two years, corporates had the option of borrowing through foreign currency loans at lower rates. The rise in the US rates and the recent sharp swings in rupee's exchange rate vis-a-vis the dollar have unnerved many a corporate.

Moreover, interest rate arbitrage seems to have all but disappeared, which makes rupee borrowing an attractive alternative again.

As liquidity tightens, banks will see cost of deposits going up and their spreads shrinking. Contraction of spreads is usually a leading indicator of rising rates.

The rise in gilt yields offers banks attractive alternatives compared with lending at tight rates to AAA-rated corporates. The situation seems to be pushing corporates towards fixed-rate loans, while banks would prefer floating-rate loans.

The RBI's policy statement, therefore, becomes very important in the current context. Given the recent CRR hike, it appears the RBI is not in a mood to keep surplus liquidity in large measure.

The bet is on whether the central bank would hike repo rate or take some other measures to drain liquidity.

A repo rate hike would be a direct indicator that interest rates are going to stay low for some time. If the RBI decides to keep rates steady, but warns banks and other segments of its intentions to tighten, the reading would be that a rate hike is round the corner. Either way, it appears rates are likely to move up.

While markets seem pessimistic on interest rates in the short term, the medium term outlook does not look that bad. The rediscovery of value in Indian stocks has brought money back into the country. There is a significant consensus on the potential of the economy among investors and the government.

A continuation of inflows cannot hence be ruled out. The case for foreign direct investment has also strengthened significantly, notwithstanding the occasional hiccups.

It is thus clear that in the medium term interest rates may not remain high. Should inflation rate drop, there would be a clamour for following easy liquidity policy.