If you are in the market shopping for credit, you probably never had it so good. Housing loans are going abegging at about 9 per cent (variable rates are lower), car companies are offering loans at ridiculously low rates as long as you buy a car, and even the relatively risky personal loans haven't looked so appealing in a long while. This, after all, is the era of soft interest rates and low inflation, where the government wants you do only one thing: spend.

Unfortunately for borrowers, though, it is also turning out be an era of interest rates uncertainty. Consider the gilt market's rollercoaster ride thus far in 2003. In January, with the fear of US-Iraq playing on market's mind, gilt prices crashed because everybody expected interest rates to harden in the months to come (prices fall because investors locked in at a lower rate of interest want to exit). As a result, the yield-it goes up whenever the price falls-on 10-year gilt paper rose from 5.8 per cent to 6.7 per cent by the middle of February.

Then, in his 2003 budget, the Finance Minister Jaswant Singh announced a 1 percentage point cut in small savings, sending the gilt prices north and lowering yield to the mid-January level. Does the market think interest rates will keep their head down? Well, not quite, because rates are hardening again. So, just what is going on here? To answer that question, we have to take a closer look at what's causing the market gyration.

Heads Or Tails?

Till mid-January, everyone believed that interest rates could go only in one direction-down. The system was flush with funds, leading people to think that even if there were a scramble for money, rates would not go up. Then suddenly, the liquidity vanished. What happened? The Reserve Bank of India mopped up Rs 11,000 crore from the market and the central government's ways and means account turned surplus. In other words, the government had tightened its purse strings, thereby reducing market liquidity. Add to that the rush from money market traders to rebuild their positions, and the picture is complete.

After the crash, gilt prices started moving up once the war clouds seemed to recede. The rally sustained its momentum on the expectation that the budget would reduce interest rates on small saving instruments. Jaswant Singh surprised the market by announcing a-higher-than-expected 1 percentage point cut, and the RBI contributed its bit by slashing repo rate and savings bank account rate by 50 basis points. This was something the market had not bargained for, and the yield promptly returned to the mid-January levels of 5.83.

With the market still on tenterhooks, there is no clarity on interest rates outlook. Most of the players think there that is nothing to worry about and that the rates will remain at the current levels in the medium term. "There is enough liquidity in the system and barring any unforeseen circumstances (like a prolonged Iraq war), interest rates should remain relatively stable in the medium term," says A.K. Purwar, Chairman, State Bank of India. Dileep Madgavkar, CIO, Prudential ICICI Mutual Fund also dismisses the current volatility as an event risk and not due to the fundamentals. "Soft interest rates regime will continue, but with huge interest rate volatility based on event risks (like wars or terrorist attacks)," he says.

But most economists are not convinced by this liquidity argument. They say that today's extra liquidity can evaporate overnight (as it happened only recently). They argue that marketmen should look at the fundamental factors that pushed interest rates down in the past and whether those factors will continue to do so in the future. This will also help us understand whether the fall in interest rates, which has been happening since 1994, can be sustained in medium term or not? So, what are these factors?

Arbitrage: After remaining isolated from the world market for decades, Indian money markets are slowly getting integrated. This phenomenon got a major push because of the arbitrage opportunities created by globalisation. But does that opportunity still exist? "Arbitrage opportunity has come down, but a 50-basis-point differential still exists," says Nilesh Shah, CIO (Fixed Income), Templeton Mutual Fund. Here's how: the rate of interest for one year in, say, the US is 1.5 per cent and around 5.5 per cent in India. Even after taking a forward cover at a cost of 3.5 per cent, it is still possible to make a slim profit.

Inflation: Further falls in interest rates can be sustained only if inflation comes down in tow. But inflation has started inching up again. If the US does attack Iraq, inflation can rise further simply because oil will be dearer to the world. Dearer oil will impact almost every product in the consumer basket. But surprisingly, not everybody is scared of inflation shooting up. Part of the reason is that the recent increase comes on a low base of February last year. If one takes a shorter time period, the rise is negligible. For example, the wholesale price index (WPI) has just moved from 167 in August 2002 to 168 in February this year.

Besides, economists point out, what the market should be watching is the expected rate of inflation, and not the current rate. On that count, confidence is high. Says Mahesh Vyas, CEO, Centre for Monitoring Indian Economy (CMIE): "The expected inflation has gone down from around 8 per cent two years ago to around 4 per cent now."

"LIC's new pension plan adds to the interest rate imbalance, besides being unfair to private insurers" Keki Mistry, Managing Director, HDFC

Economy: Low economic activity and a consequent low demand for funds from the corporate sector was another factor that contributed to low interest rates. But the economy is showing signs of accelerating, and when that happens, investment will pick up and the resultant demand for capital could push interest rates a few notches up. "With the restructuring that happened during the last two-to-three years, companies in India have become stronger and private demand is expected to go up now," notes Saumitra Chaudhuri, Economic Advisor, ICRA.

Fiscal Deficit: The huge fiscal deficit (around 11 per cent if one adds state deficit too) can theoretically put pressure on inflation and interest rates. Why isn't it working in practice? "It is not adding to inflation because the high fiscal deficit is met through market borrowing and not through adding money to the system," explains Vyas of CMIE. It is also not putting pressure on interest rates since corporates are staying away from the market. Once they enter, interest rates will almost certainly rise.

Real Interest Rate: The long-term real rate of interest (the difference between the nominal rate and inflation) can't be out of tune with the rest of the world, especially in a globalised environment. For example, the yield on 10-year paper in the US is around 4 per cent, while in the EU it is marginally higher at 5 per cent. The real interest rate, however, works out lower: 3 per cent for both the US and EU. Add this to India's inflation rate of 4 per cent and a comparable interest rate works out to 7 per cent. The point: "The rates that we have seen recently-below 6 per cent-are simply not sustainable in the medium term," contends Chaudhuri of ICRA.

Structural Problems: There are several structural problems in the interest rate regime that keep the rates high. First, the rates of return offered by contractual savings (like PPF and post office fixed deposits) are much higher than those of comparable bank FDs. This anomaly can't be sustained for long. Second, is the interest rate fixed by the RBI for savings bank account. This distorts the interest rate structure by not allowing the short-term FD rates to fall. In fact, the 1 percentage point cut in small savings and the 50-basis-point cut in savings rate are steps intended to correct the imbalance.

But is that enough? No, say experts like Keki Mistry, Managing Director, HDFC, and that's the reason why current yield is higher than mid-January levels even after the rate cuts. What's worrying the market, however, is that Budget '03 actually adds to the interest rate imbalance. The 9 per cent assured return pension scheme, Varisht Bima Yojana, from the Life Insurance Corporation, for senior citizens is one big example. "It is a step backward. In addition to creating a problem to the interest rate structure, it is also unfair to the new private insurers," says Mistry.

"There is enough liquidity and barring unforeseen circumstances, the rates should remain stable" A.K. Purwar, Chairman, SBI

Fence Sitting

But as long as global markets continue to face uncertainty over the Iraq situation, interest rates will be perched on the fence. The banks-except for the Bank of Baroda, which cut FD rates essentially for correction-are refusing to reduce their fixed deposit rates or loan rates, and are waiting for the RBI to announce a rate cut. But the central bank has already made it clear that it is in no hurry to cut the bank rate. Even the gilt yield is hard pressed to cross the mid-January barrier of 5.8 per cent because every time the prices move up, players rush in to book a profit.

Higher interest rates is bad news for the corporate sector, though. It will torpedo the industrial recovery underway. But there is one set of institutions that will lose heavily if interest rates shoot up. These are the PSU banks, which have stocked up on gilts. In fact, most of them took a hit during the gilt market turmoil in January. However, there could be worse in store. Most of these banks have been propping up their bottomlines thanks to their gains in the gilt market. Once prices crash, they will no longer have this profit cushion. That means bank stocks, which have been buoyant on Dalal Street, could start ebbing.

Worryingly for marketers, dearer loans will dampen consumer appetite too. Fewer consumers may decided to buy consumer durables or cars on credit. But what may still not get affected is housing loans. That's because the National Housing Board has reduced the refinance rates by around 2 per cent. The new NHB rates for loans over Rs 10 lakh are 7.7 per cent (fixed rate) and 7.1 per cent (floating rate). Around a quarter of housing finance companies' needs are met through the NHB and, therefore, the rates fixed by the board set the trend. (Thank god for small mercies, did you say?).

There is only one section that is happy with higher interest rates and that is of the pensioners, who survive on fixed income. But even their gains would only be relative, since their staple such as post office deposits, RBI relief bonds and now LIC's new pension plan offer rates that are higher than the market rate by one to three percentage points. Cautions Shah of Templeton: "Those who invest in these instruments should not expect their returns to go up along with the market rate." As for the gilt traders, they probably should get used to living with uncertainty.