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.
| Who Gains?
In general, higher interest rates
spell bad news.
An increase in interest rates will push up costs and reduce
margins, and likely affect recovery.
Those that are heavily invested in gilts will lose
when yields fall, besides they will lose an important profit
Will dampen credit-led purchases, although pensioners
dependent on interest income will be happy.
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
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
A.K. Purwar, Chairman, SBI
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
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