The Inflation Dragon Returns

When headline inflation was falling, commerce and industry associations used every forum to point out that nominal interest rates were not falling with the same momentum. It took a strong-willed banker to call their bluff. The industry captains who want nationalised banks to cut their PLRs to 10 per cent have no qualms banking on foreign or even private banks and paying a PLR of 14 to 15 per cent.

With headline inflation rising to a 73-week high, bankers expect the industry to switch into a panic mode. "The RBI is powerless to stem the upward revision in rates," a top banker said. His point was that demand for funds will compete with government borrowings.

 

A cross section of bankers was divided on whether the interest rate structure would stabilise at current levels or whether it will inch up further. But all bankers agreed on one issue: The RBI is in a dilemma. If there is stringency in the system, the RBI is unlikely to cut the CRR because it has to keep an eye on the inflation. The concern over tightness in the money markets keeps coming back because of huge government borrowings of Rs 1,16,861 crore this year. Though the RBI has completed 21 per cent of the targeted total borrowing programme, the markets are quite sceptical if it will be able manage the rest without conceding a higher coupon in the balance part of the year.

"The interest rate is determined by the movement in inflation rate. Looking at the current scenario, it appears that inflation is headed southwards," said K C Chakrab-arty, Bank of Baroda general manager.

"Moreover, the world-over interest rates are moving up, while in case of India, they are already higher than that they should be. So, if the government manages its show well there could be convergence between India and the developed countries," he added.

In the recent past, interest rates have been hiked in the EU, Canada, Korea, Switzerland and Hong Kong.

To this, Lyon Jonathan, chief executive officer and country manager at BNP Group, India said, "India is isolated from other countries, so the rise in interest rates in the international markets will have little bearing here. But there could be a trickle down impact, owing to huge oil imports for which India has to buy dollars."

Bankers said if inflation continues to rise, the RBI may begin to tighten money supply.

Explains V H Ramakrishnan, general manager at Bank of India, "If inflation rate goes up, industrialists will increase their inventories to book inflation profits. This, in turn, will lead to increased demand in demand credit, and banks may run short of liquidity. This could lead some banks to raise their deposit rates. Following which, they will be forced to hike their lending rates."

Thus, even if the RBI does not touch the interest rate structure, the rise in inflation would trigger a natural rise in lending rates. But if the RBI reduces CRR to address the liquidity issue, it then could end up feeding inflation numbers.

But there are rays of hope. As Chakrabarty says, it depends on the quality of government spending. The interest rate is expected to be stable at the current level for about a couple of months, but eventually it will be determined by other factors.

Most bankers noted the headline inflation rate of 2 per cent was a temporary phenomenon, and it has returned to the secular rate now. Bankers said inflation can be expected to rule between 5 to 6 per cent over the next five years. The downward drift in interest rates in the last 18 months, they said, accommodated a temporary fall in inflation numbers, but if the long-term scenario points to 5 per cent-plus inflation, interest rates would inevitably head northwards.

Bankers said the economy has reached a critical point where the RBI may have to differ from the finance ministry on the appropriate response to the inflation numbers.

The government, of course, loses little in inflation rises.

Even the RBI deputy governor, Y V Reddy had said in his speech at Hyderabad in August 1999 (when the inflation was around 2 per cent) that "There is need for working out a national consensus on the acceptable level of inflation. What may be called inflation-consensus should be followed by an explicit inflation-mandate."

Earlier, the RBI annual report for 1993-94 also pointed out, "There is need for a broader national consensus before prescribing a mandate for the central bank."

However, Ravi Kumar, senior executive vice-president and head of corporate banking, ICICI Bank, feels otherwise. He is of the view that rates should fall further.

"The real rate of interest is still high and there is room for a fall in rates by at least 1.5 percentage points, though inflation is expected to range between 5 to 6 per cent. Last year, when inflation touched less than 2 per cent, it was particularly so because the base was low, but the case would be different now."

Ravi Kumar said inflation would remain stable till about September and later

on it would depend on the quality of government spending.