Since March 2010, in the last 14 months, the Reserve Bank of India (RBI) has hiked the reverse repo rate on nine occasions. In combination with repo rate (which is the current operative rate), it means that RBI’s key policy rate has more than doubled during this period—from 3.25% in March 2010 to 7.25% at present. It may be recalled that the wholesale price index inflation, which was in negative territory in July 2009 went up to cross the double-digit mark at 10.36% by March 2010. The main contributor to such high inflation was food article prices, which increased at close to 20% per annum last year. During this period, three-month commercial paper (CP) rates also moved up from 3.5% then to about 10% currently, reflecting higher funding cost for corporate India.
Economists expect that higher interest costs and tight liquidity may adversely affect the GDP growth rate in the near term even though India’s economic fundamentals remain extremely strong. The question that, therefore, gets invariably asked in every discussion these days is: “Where are the interest rates headed next?”
In its monetary policy review for 2011-12 earlier this month, RBI has sought to maintain an interest rate environment that moderates inflation and anchors inflation expectations. It would imply, therefore, that RBI may continue to hike policy rates and maintain a tight liquidity stance till such time that inflationary expectations moderate sufficiently. There are three important variables that may affect inflation going forward. Monsoon will have a significant impact on inflation. As discussed earlier, last year inflation was driven largely by high food prices, which have moderated significantly over the last few months. A normal and timely monsoon will indicate stable food and vegetable prices and have positive impact on inflation.
The second critical variable would be global oil prices. In the last few months, following disturbance in North Africa and the Middle East, global crude prices have moved up sharply on apprehension of reduced supply from these areas. Recent collapse of a nuclear power plant in Japan following a massive earthquake has increased expectation of higher reliance on thermal power further supporting higher crude prices. With continued uncertainty on geopolitical environment, oil prices are expected to remain firm putting pressure on inflationary expectations.
Finally, price movements in other global commodity such as copper and aluminium will also have a strong impact on inflation. As per the current assessment, inflation is likely to remain elevated in the first half of the year. Assuming a good monsoon and gradual stability in North Africa and the Middle East resulting in lower oil prices, inflation may moderate thereafter.
Short-term interest rates
Let us examine the trajectory of short-term interest rates first over the next year. Last year, telecom companies borrowed aggressively from the banking system to fund the bids at 3G and broadband telecom licence auctions. Credit pick-up from other sectors also remained robust. With the government also holding large cash balances, the system liquidity turned negative. The credit-deposit ratio of the banking system was above one for the better part of the year, which means that banks were lending more than fresh collection by way of deposits.
Following a record subscription in Coal India’s initial pubic offer, system liquidity came under severe strain, necessitating special liquidity infusion measures from RBI in a counter-cyclical move. As a result, banks began to sharply hike deposit rates in order to attract fresh deposits to improve the liquidity and balance sheet ratios. By this time inflation was consistently exceeding all expectation and market rates started pricing in expectations of stronger hikes by RBI.
Consequently, short-term rates moved in a fast-forward manner to price all these negatives and spreads between repo rate and three-month bank CD rate widened from about 50 basis points last year to above 400 basis points in March. In the new financial year in April, liquidity situation improved with government spending and fresh system flows. With the financial year-end pressure behind and in a more balanced liquidity environment, short-term rates (up to one year) may already have peaked in the current interest cycle. They may now fluctuate between its March high and April lows. In other words, short-term rates should remain within the March highs of 11-12%.
Long-term interest rates
In so far as long-term rates are concerned, additional factors of government borrowing program, growth in credit and global bond markets will also play a role. While very high oil prices may result in higher subsidies, volatility in equity markets may undermine disinvestment targets. Further, poor monsoon may result in additional burden on government finances.
All the above factors will affect fiscal deficit and inflation. Thus, better visibility has to emerge on these factors before a decisive view on long-term bond yields can be available. However, currently the yield curve is pretty much flat with one-year treasury bill at 8.30% and 10-year government securities at 8.35%.
With overall interest rate environment uncertain and with RBI’s current focus on moderating inflationary expectation, one would expect a small rise in 10-year yields, maybe a push towards 8.50% levels, in the near term.
Mahendra Jajoo is executive director and chief investment officer, fixed income, Pramerica Asset Managers Ltd.