If economic growth in India leads to large inflows of capital, the chances of interest rates rising are low - if that doesn't happen, they will.
Roopa Kudva
MD & CEO, Crisil Ltd
‘Cutting repo won’t help. The repo and inflation are lower than they were in 2004, but G-sec and home loan rates are higher — government borrowings mute the RBI signals’
The fiscal deficit of the central government shot up to 6.2 per cent of GDP against the target of 2.5 per cent set for 2008-09. For 2009-10, it is budgeted at 6.8 per cent of GDP. For financing the fiscal deficit, the government nowadays relies less on external borrowings and printing money and more on domestic borrowings. Consequently, the government’s domestic borrowings almost doubled from Rs 1,31,768 crore to Rs 2,61,972 crore between 2007-08 and 2008-09. The borrowings have been projected to increase by 52 per cent to Rs 3,97,957 crore in 2009-10.
When the government needs to mobilise large sums of money via borrowings, it has to offer higher interest rates to attract enough investors. Thus, financing large deficits through borrowings immediately puts upward pressure on government bond yields. The yields on government bonds are regarded as the measure of the risk-free rate in the economy and act as benchmark for other rates. The rise in benchmark rates, therefore, raises the floor for other rates as well.
When it was evident that the Indian economy was slowing at a pace faster than expected earlier, RBI veered towards a softer monetary policy in the middle of last year. Since then, through a series of swift actions, it has pumped in a significant amount of liquidity and reduced the repo rate by 425 basis points to bring down interest rates. Despite RBI’s action, interest rates remained sticky and lending activity sluggish. This was due to a lack of confidence and the bankers’ expectations of an increase in demand for credit. The weak monetary transmission made monetary policy less effective as it extended the lag with which rate cuts impact the economy.
As opposed to the sluggish response of the credit market, the money market had initially responded favourably to RBI rate cuts, and so 10-year G-Sec rates swiftly came down from 9.4 per cent in July 2008 to 5.3 per cent by December 2008. Thus the risk-free interest rate was alert to RBI signals. But all this soon reversed. The rapid expansion in the government’s borrowing programme has pushed up the 10-Year G-sec yield to 7 per cent now.
We all know that soft interest rates and expansion of commercial and retail credit, aided by a falling government deficit, was a critical factor behind the high growth observed since 2003-04. Although the repo rate and inflation today are much lower than they were in 2004, the general lending rates are much higher. For example in 2004, the repo rate was 6 per cent, 10 year G-sec around 5 per cent and home-loan rate below 8 per cent. Today the repo rate is down to 4.75 per cent but the G-sec and home loan rates are much higher, around 7 and 10 per cent respectively.
Although, the major reasons behind the weak transmission of the RBI signal of rate reduction to general interest rates are the financial-sector disruptions and high credit risk, increased government borrowings are further muting this transmission. When growth rate picks up and demand for funds from the private sector increases, high borrowings will pressurise interest rates more and begin to crowd out private investment. RBI’s rate-reduction cycle is soon coming to an end. At the most, one more mild reduction in repo rates can be expected. In this scenario, rising government borrowings imply that going ahead, the interest rates will head upwards, without testing the lows RBI was aiming at.
Nandkumar Surti
CIO – Fixed Income, JPMorgan Asset Management India Pvt Ltd
‘Once growth picks up, capital from abroad will come in looking for high returns — there will be enough money to meet the needs of government and the private sector’
Most central banks across the globe have made calibrated efforts to keep the interest rates low for the past many months. The rationale is that low interest rates, combined with various fiscal stimuli, will revive the sagging economy by beefing up demand from both companies as well as from consumers. The counter impact of stimulating the economy is a high fiscal deficit resulting in high government borrowing.
At this critical juncture, central banks cannot afford to relax and allow rates to move up as there are many hurdles on the road to recovery such as weak consumer balance sheets, rising unemployment, tight credit conditions (especially for the consumer), rising loan losses and weak final demand. Real interest rates are too high, given the pace of the economic recovery and inflationary expectations. Excess capacity in manufacturing and labour, coupled with weak final demand, will keep inflationary pressures low.
The expected revival of economy and free fall in the market in March have encouraged investors to buy riskier assets and sell government bonds and this has pushed yields higher. However, the path of recovery is very slow and market participants will adjust portfolio allocation (safe assets to risky assets and vice versa), putting pressure on respective asset classes in the short-term.
The main theme of Budget 2009-10 was to get growth back on track through higher expenditure, thus widening the fiscal deficit. The fiscal deficit for 2009-10 is estimated at 6.8 per cent of GDP against 5.5 per cent of GDP estimated in the interim budget announced earlier this year. However, the high fiscal deficit is unlikely to put a substantial upward pressure on interest rates. Firstly, the amount of borrowing per month is likely to be much lower than what the market has seen in the course of last six months. Secondly, inflation expectations at 5-6 per cent by March 2010 would be caused more by commodities (supply-side constraints) rather than manufacturing or wage-price inflation. We saw that during 2000-2004, the RBI policy has been accommodative to rising inflation where inflation can be attributed to supply-side constraints. Further, if commodity prices continue to rise sharply in the face of excess liquidity and gradual economic recovery, controls are inevitable in commodities to keep inflationary pressures in check.
Currently, India needs capital to attain a high-growth trajectory. However, we do not expect high fiscal deficit resulting in crowding out of capital for the private sector. The current high public spending at the cost of fiscal prudence will help achieve growth sooner rather than later, and will result in huge capital flowing in the country as liquidity chases high growth. This will provide enough capital to both private and public sectors. Also, a higher growth rate will help to get the fiscal deficit back on track through better revenue collections.
The most important catalyst for the direction of interest rates is how the central bank and the government manage the borrowing programme rather than the borrowing programme itself. In the current environment of heightened economic uncertainties, the RBI would prefer a ‘wait and watch’ policy rather then increasing interest rates as a pre-emptive measure.
