A Warning Shot

The Fed rate hike adds an immediate dimension to the RBI's dilemma

Fears of upward pressure on interest rates has resulted in the reversal of sentunent in the overnment securities markets to a bearish one. Market participants are also wary of yesterday's hike in the US Federal Bank discount rate which could certainly have short-term implicatlons on domestic interest rates as well, dealers said.

The Federal Open Market Committee (FOMC) yesterday voted a 50 basis point increase in the overnight bank lending rate to 6.50 per cent, its highest level since 1991. More importantly, it left the upside open for a further rate increase when it said "the US economy faces the threat of rising inflation." Agencies have quoted US banks and money market players as expecting a rate hike as early as next month.

 

The domestic implications are threefold. Firstly, the US rate at 6.50 per cent is very much in the vicinity of the domestic bank rate of 7 per cent. Worse, with the Fed's arched brow on inflation, another round of hikes would bring it even closer to the domestic bank rate.

Dealers said unless of course the Reserve Bank of Indta (RBI) wants to go down in the record books with interest rates equal to the US rates, it would be under pressure to maintain the differential and hike the bank rate.

The second implication comes out of the unsterlised intervention in the forex markets. A hike in US treasuries may dampen the portfolio (foreign institutional investor) flows into the country. The RBI would then have lesser dollars flowing into its books. Correspondingly, the amount of rupees that it releases into the system will be reduced, affecting the underlying liquidity trends.

The third implication is more deep seated. If the Fed is worried about underlying inflation, driven by consumer demand even tnough technology-led productivity gains are obvious, then the possibility of US demand feeding into a global increase in manufactured product prices must be real. For emerging economies, that becomes a real threat, almost at par with oil price-led inflation. With the RBI projecting an inflation outlook of 4.5 per cent, the imported inflation component could easily add a percentage point. And with inflation between 5 to 5.5 per cent, it may be difficult to sustain the trend of falling yields.

That being the central dilemma, the RBI' may not be able to resolve it in the immediate future. There seems to be no immediate justification to force a rate hike. Liquidity is more than comfortable, as indicated by the over subscription of inore than 100 per cent at the recently auctioned three-year paper. And the RBI has also of late decided not to resist the market in its sudden appetite for short term paper.

Though this clashes with the RBI's possible interest rate course market dealers say RBI's current stance could be driven by the simple fact that it has little option, especially due to the large size of the government borrowing programme. Dealers were of the opinion that with the forex market turning volatile, the central bank s attention could temporarily be diverted away from the money markets and some important changes might be postponed for a future date.

STCI general manager S R Kamath said, ~Private placements could be a viable option for the apex bank this year, much more than last year. This is because there has been no net monetisation year as securities sales have been greater than purchases. Though this flexibility is available RBI, might not yet opt for this in the midst of ample liquidity." Dealers said it was possible that the apex bank may consider revision of domestic interest rates after September 2000.

"Once around 75 to 80 per cent of the year's gross borrowing programme is completed, the RBI might find it suitable enough to increase interest rates. Since the Indian market is not as developed as that in the US, it might not be feasible to have such low interest rates," a market dealer said.

However, Discount and Finance House of India managing director M R Ramesh, said, "There might not be too much impact in the domestic market of interest rate hikes in the US largely because the rupee is not as yet fully convertible."