Interest Rates: Short-Lived Relief?

The corporate sectors euphoria over the prospect of lower interest rates, that surfaced immediately after the credit policy, seems to be dying down just as fast. And although opinion is sharply polarised over which way interest rates will actually move in the medium term, the mood in the corporate sector is no longer universally upbeat.

Yet, less than two months after the credit policy, blue chip companies like the Industrial Development Bank of India (IDBI), Reliance, ACC, L&T are aghast to find investors reluctant to pick up their debt offerings at around 14 per cent. If these issues did go through, it was because of the hefty incentives the companies were compelled to throw in, say corporate analysts. The effective cost of funds for the companies was, thus, much higher - 16 to 17 per cent.

In fact, a blue chip public sector unit (PSU) like IPCL was reported to have dropped its plan of a Rs 450 crore bond flotation because it found no takers for the 14.25 per cent offering it had planned. IPCL is believed to be restructuring the instrument, which means that it was planning to raise the return. The management of Indian Rayon, too, is reported to have dropped its debenture issue and had decided not to tap the market for the time being.

Even more remarkable is the case of IDBI, the blue chip financial institution that had already floated a Rs 1,000 crore bond issue at 13.5 per cent. Market resistance restricted the subscription to a mere Rs 300 crore at last count.

These pressures on borrowing rates have sent shivers down the spines of corporate finance managers. Are interest rates in general poised to go up? Around the middle of April, money managers believed that the rates would remain low until September when the demand for credit picks up following the busy season. But the pressure on borrowing rates seems to be setting in much earlier, if the indicators are anything to go by.

It was Reliance that broke the back of the market, says Manoj Rane, chief dealer of IndusInd Bank. In fact, it was the Reliance bond issue of Rs 140 crore at 14.5 per cent which was believed to have set the benchmark for triple A rated companies. But few companies, if any, with a similar rating, have been able to raise funds at lower rates.

Why banks are staying away

Banks, who are the major investors in corporate debt paper, have their own reasons for shying away from these issues. As N Gopalkrishnan, managing director of SBI Gilts explains, the prime lending rates of banks has been around 14 per cent, but the spreads are coming down because of competition. The cost of funds is steadily going up for banks if one takes into account the interest cost and the servicing. On the other hand, there is the pressure on them to reduce the lending rates. The risk factor is not compensated fully, says Gopalkrishnan.

Additionally, from a banks point of view, investment in corporate bonds is as risky as direct lending since it has to provide 100 per cent provision in terms of capital adequacy. And given the fact that the risk factor in both cases is the same, banks would obviously decide on investing in paper that fetched a higher yield. Corporate paper has to compete in this context with gilt edged paper, which is totally risk-free (though yields are about one per cent less). Investor resistance at around 15 per cent is therefore only to be expected, according to Gopalkrishnan.The crucial point is that this factor could well push up lending rates as well.

The tightening of the provisioning norms of banks has, thus, a lot to do with the pressure on their lending rates. But there are also other factors like a pick up in credit demand witnessed in recent months. According to the RBI data, credit disbursal by scheduled commercial banks showed an increase of 10 per cent in the first week of May 1997 compared to a year ago. Considering that food credit had declined during this period, credit to the commercial sector had increased by nearly 11 per cent. This pick up in demand for credit has come much before the expected rise in September, and has been putting pressure on interest rates, point out bankers.

Only a few bankers like Allahabad Bank and UCO Bank are looking at corporate bonds at levels lower than a 14 per cent yield. And that is only because the abysmal levels of service they offer has led to a flight of borrowers (and therefore low credit offtake) from these banks, says the chief manager of a large bank. But they too could turn away from these instruments the moment they feel pressure of demand for credit from the corporate sector, he points out.

Up and away?

So what does the future look like? If the FI chiefs statements are anything to go by, they can only move upwards. K V Kamath, chief executive officer of ICICI has gone on record as saying: The market has definitely hardened over the last few weeks. In the long-run, interest rates will rise further since demand for infrastructure projects will pick up. The demand for credit from the manufacturing sector will go up. And H K Khan, chairman and managing director of IDBI has said interest rates have bottomed out, which means that they can only move northward now.

In fact, ICICI after slashing short term lending rate to a minimum of 13.5 per cent only about a month back, is apparently having second thoughts and may actually be planning to hike it, if what Kamath said is any indicator. Signals are coming through, though slowly and erratically yet, about reduction in liquidity. Monetary experts had until now believed that the interest rates will remain low for at least six months. They now face the danger of being proved quite wrong by the pulse of the market.

In any case, it was at the shorter end of the market that interest rates had taken the most pronounced dive. Long term rates too have declined, but only marginally until now. The yield to maturity (YTM) of ICICIs one year paper has increased by 75 basis points in a matter of just three weeks - from 11.25 per cent to 12 per cent. The YTM on its 18 month paper, too, has gone up to 12. 5 per cent. What is more important, ICICI is planning to raise more resources from the markets at a higher rate. The cost of one year paper is now expected to be higher than 12 per cent, according to ICICI sources.

And if that happens, the financial institution will have to raise its medium term (one year to 30 months) prime rate from 13.5 per cent to at least 14 per cent, they add. In fact, money market players feel that interest rates are at their rock bottom now and can only move upwards. This also seems to be true of longer term corporate paper. The three year institutional paper is now fetching a YTM of 13.5 per cent marking a premium of at least 50 basis points in just one month.

Notes of dissent

Not all corporate experts agree with this line of argument, though. Sanjay Kothari, director (finance), Industrial Meters Ltd, for example, does not agree that the interest rates are moving upwards. The market is still flush with liquidity and there is no reason to fear that rates will go up, he points out. If banks are resisting the offerings, it is because they have become very cautious after what happened at Indian Bank, he says. Moreover, capital flows from abroad are continuing, compelling the RBI to sterilise the flows to stop the rupee from appreciating. These operations add to the liquidity in the system which forces rates to stay low, he explains. Only if the flows were to stop for some reason would there be a cause to worry on this front.

Additionally, corporate borrowers have plenty of options to borrow money at low cost, and therefore banks resistance to their offerings does not in any way signify an upward pressure on interest rates, says Kothari. He mentions routes like FCNR(B) and external commercial borrowings (ECBs) through which companies can raise working capital loans at lower rates. They, therefore, have no compulsion to put up with high bank lending rates if they do increase the rates, he emphasises.

The gilts complex

In contrast to the corporate sector, the government borrowing from the market has so far not faced much resistance. But this situation, too, might be changing. The government borrowing programme is likely to continue uninterrupted. The rate on government securities has been moving southward will that continue? No, point out market players. In September, some heat may be seen in the market, they point out, as large repayments fall due. Others, however, expect the government will come out with another flotation to practically roll over that amount.

Many corporates these days are said to prefer dollar loans to rupee loans. And as the dollar flow keeps on, which is expected to strengthen in the coming days, RBI will have little option but to neutralise its impact on the exchange rate through sterilisation operations. How long the central bank will be able to sustain it is, of course, an open question. Once it stops doing it, the interest scenario will be quite different.

Notwithstanding the excess liquidity in the inter-bank money market, banks are slowly becoming wary of subscribing to government paper. This reflects the unwillingness of banks to go for lower coupon rates. The central bank has been quite active around this time of the year, as far as its market borrwing is concerned. It is astonishing that it has already picked up Rs 14,000 crore from the market in the first two months (April and May) of the current financial year. The amount constitutes 40 per cent of the net borrowing target of the government for the year.

So the near future does not look as rosy. It is apparent that the authorities too are worried at the emerging trend in the economy as far as interest rates are concerned. The RBI governor, C Rangarajan, had last week voiced this concern. Speaking at the Indian Merchants Chamber last week in Mumbai, he urged bankers to reduce their spreads and keep interest rates low for borrowers. He emphasised that while monetary policy will be supportive in bringing down interest rates, we also need to take note of certain other conditions that must be met.

That the central bank perceives a potential pressure on interest rates and recognises heavy government borrowing as a major cause behind this is apparent from what he went on to say further. The RBI governor has actually pointed out that the governments borrowing programme will have to be maintained at a level that does not put pressure on available resources.

But if one goes by other indicators, the situation seems to be fluid. Three month government paper is going at 7 per cent while six month commercial paper of blue chip corporates are available at 11 per cent. An interesting case in example is the case of Reliance Capital, an AAA rated finance company. It recently floated a Rs 100 crore, five year paper and received offers for Rs 500 crore. Since a finance company carries its due risk, the rate, according to market circles, is perfectly reasonable and in keeping with the downtrend in interest rates that the credit policy threw up in the economy.

So, where do these conflicting trends leave us? Are interest rates heading northward? The picture is far from clear, but there are signalscloudy ones emerging. Figures indicate that with there being ample liquidity in the system still, there is no valid reason for rates to go up. But liquidity is only one factor that determines interest rates. Rigidities in the system is another. Could it be that despite liquidity we are witnessing a rise in the rates?

And though the banks mention their cost of funds as a major deterrent, it is more likely that it is the expectation of rates going up that is inspiring them to resist the current offerings. The speed at which the RBI has been garnering money from the market for the central government raises doubts in the mind of analysts: is the central bank trying to make the best of the low level market and raise as much as it can within a short period? Is the RBI expecting the rates to go up before long, and therefore trying to raise money for the central government before that happens?

As the debate rages over which way interest rates are headed, this is a crucial question that money managers are racking their brains over. Their conclusion: the relief on the interest rate front is possibly going to be short-lived.

Abhijit Doshi

A sudden let down

Corporate finance managers are now realising that the sudden dip in the lending rates of both banks and financial institutions (FIs) that followed the April 1997 credit policy concessions ( such as the removal of cash credit ratio on inter-bank liabilities and the swap facility extended to banks) may not be a long standing certainty. This realisation has come at a time when the delinking of banks investments in debt instruments ( from the earlier overall limit of 5 per cent ) has whetted the corporate sectors appetite for cheap funds even further.