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The great Indian rate trick

November 11, 2004

Till recently, the bearish sentiment in the gilts market was largely thought to impact only bank bottom-lines. This week's developments suggest that they're going to affect the general public and India Inc too. Despite the Reserve Bank of India's cautious approach to interest rates, the impact is being felt faster than expected.

On Monday, for instance, the RBI set the cut-off yield of a five-year government bond at 7.20 per cent at an auction. This is 241 basis points higher than the five-year bond yield on April 1, the first day of fiscal 2004-05, implying that demand for bonds is falling.

The last time the five-year bond yield was seen at such a high level (and therefore prices were so low) was in June 2002.

The official acknowledgement of rising rates might not have attracted much interest were it not for other developments. Hours before the result of the bond auction was made public, Housing Development Finance Corporation (HDFC) chairman Deepak Parekh announced a 50 basis points increase in HDFC's floating rate home loans across maturities -- the first such increase after more than four years.

Two days later, Bank of India and Bank of Baroda, two large public sector banks, raised their deposit rates by 25 to 50 basis points.

The twin triggers for rising interest rates are a 50 basis point hike in banks' cash reserve ratio (CRR) to 5 per cent and a 25 basis point hike in the short term repurchase or repo rate to 4.75 per cent in the October monetary policy. The CRR increase sucked out about Rs 9,000 crore (Rs 90 billion) worth of liquidity from the system.

Of course, interest rates had, in fact, started hardening even before the RBI announced those measures. But they gathered momentum after the central bank's move. Why? Before answering this, let's take a closer look at the government securities market.

Since the beginning of the fiscal year, the yield on the 10-year benchmark government bond has risen by 220 basis points -- from 5.12 per cent to 7.32 per cent.

At the lower end of the maturity spectrum, the yield on the 364-day treasury bill has risen by 155 basis points since the beginning of the fiscal. Similarly, for the 91-day treasury bill the rise has been 140 basis points since April.

The RBI's contention has consistently been that in the Indian context, the rise in official rates would be calibrated and, therefore, would not be as fast as the developed markets including the US. This is because the rates in India did not drop as sharply as elsewhere.

But in the US, the rise in yields on 10-year US Treasury has been about 33 basis points since April. Similarly, the rise in five-year US Treasury has been only 66 basis points in the same timeframe (in the interim, they did go up further but subsequently dropped).

This is despite a 75 basis point three-stage hike by the US Federal Reserve in its base rate since June this year. In contrast, the Indian central bank has raised its short-term rate by only 25 basis. So it's clear that the rise in the market rate in India has been faster than that of the US.

Why? The critical factor is inflation. With core inflation hovering at 2 per cent in the US, the real yield (that is the nominal rate minus the inflation rate) of bonds across maturities is positive.

But in India's case, with the inflation rate at 7.38 per cent, even after the recent rise, the real yield is negative. Even when the 10-year US treasury yield dipped to 3.09 per cent in June 2003, the real yield remained positive since inflation at the time was hovering at 1.2 per cent.

In other words, US bond yields have consistently factored in the inflation outlook. This has not been the case in India, which does not have a history of low inflation even though there has been a secular decline in inflation over the years.

The average inflation rate was 5.4 per cent in 2003-04. Bond yields, it appeared, continued to build in a benign if unsustainable inflation outlook.

Naturally, since the inflation rate has already breached 8 per cent and continues to rule over 7 per cent, bond yields cannot move at a slow pace. The market has started pricing in another round or two of interest rate hikes over the next few months.

But this is only one side of the interest rate story. Looking at it from a different angle, it is almost tempting to say that the monster of rising rates is a creation of the RBI and the finance ministry.

Both the banking regulator and the government have been hounding banks for their relentless chase of government paper and apathy towards commercial lending.

As a result, with the first sign of a pick-up in credit demand, banks started lending with a vengeance and almost stopped investing in government bonds.

On a year-on-year basis, the credit offtake has risen by 28.8 per cent against 12 per cent a year ago.

No wonder, growth in banks' investment in government securities is down to Rs 70,453 crore (Rs 704.53 billion) or by around 11 per cent year-on-year, sharply lower than Rs 1,20,562 crore (Rs 1,205.62 billion) or over 23 per cent a year ago.

The consequences of this can be dangerous for the fisc and the economy. The federal government has completed Rs 93,000 crore (Rs 930 billion) of the Rs 1,25,000 crore (Rs 1,250 billion) gross borrowing programme for the year. Rising interest rates will raise its cost of borrowing and impact the fiscal deficit.

Second, the impact of the rise in bond yields is already spreading across the banking system. When the five-year sovereign yield shoots up to 7.2 per cent, can a 20-year home loan to an individual be priced at 7 per cent?

In any case, commercial banks can raise lending rates without tinkering with their PLR (prime lending rate) which for all practical purposes has become an MLR (maximum lending rate).

The average return on loans for most banks is 7 to 8 per cent while the PLR is 11 to 12 per cent!

This means that there is a 4 to 5 percentage point cushion available to banks to raise their rates. This can be done without inviting the attention of the finance ministry or the RBI since PLRs remain unchanged.

The RBI has been extending liquidity support by releasing funds through the repo window from where banks can draw down liquidity at 6 per cent. Early this year, the trend was just the opposite with banks parking Rs 60,000 crore (Rs 600 billion) or more of excess liquidity with the RBI.

The central bank has also cancelled a treasury bill auction of the market stabilisation scheme (MSS) which was floated to suck out excess liquidity from the system. What is more, it has also started intervening in the foreign exchange market, buying dollars and releasing rupees to ease the strain on liquidity. Yet interest rates continue to rise.

What else can the RBI do? There is no dearth of instruments. It may not be able to roll back the CRR hike since that will defeat the very purpose of tightening liquidity to fight rising inflation. But it can certainly go slow or even cancel the rest of the MSS.

The net MSS outstanding is Rs 56,185 crore (Rs 561.85 billion) against a ceiling of Rs 80,000 crore (Rs 800 billion). Overall, the central bank had floated bonds and treasury bills worth Rs 83,185 crore (Rs 831.85 billion) so far and redeemed Rs 27,000 crore (Rs 270 billion).

Under the MSS, the RBI has been floating Rs 1,500 crore (Rs 15 billion) worth of 91-day T Bills every week and Rs 1,500 crore worth of 364-day T Bills every fortnight.

If it stopped issuing fresh securities under the MSS, the redemptions of short-term treasury bills could infuse money into the system.

Another way of tackling the situation could be to send an interest rate signal through government bond auctions. It can set the cut-off yield at a level where it is comfortable to check the pace of the rate rise and take a partial devolvement on itself.

Even in a free market, intervention is welcome if it helps avoid a bigger problem. After all, if the interest rate trajectory gets out of control the system will end up paying a greater price in terms of growth.

Of course, none of this is required if RBI is in control of the situation. What we are seeing today could be a deliberate ploy by the regulator: it wants interest rates to rise but does not want to be seen pushing for it.

Already, the bank rate (6 per cent) is becoming the floor rate for the overnight call money replacing the reverse repo rate (4.75 per cent) and money is becoming more expensive in every market.

This is a shrewd strategy but even so, the RBI must communicate its intentions to the market more clearly to clear the uncertainties.

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