Low rates to continue

Pradeep Dokania

Interest rates in India have historically followed the direction given by policymakers coupled with a supportive environment. In the next fiscal 2003-2004 we expect the broad trend of lower interest rates to continue.

We also expect policy to continue to strive to direct interest rates lower. Both policy makers, the government of India and the Reserve Bank of India, have clearly indicated their bias for soft interest rates.

Before moving forward to expectations it would be useful to note that there are a number of 'interest rates' that exist in the Indian economy.

Gilt yields, corporate bond yields, lending rates, deposit rates, contractual savings rates and the RBI reference rates, are all part of the interest rate structure.

The gilt market being the most deep and liquid is quick to reflect market expectations of future interest rate movements. This market, however, at times also lags interest rate moves by the RBI.

We expect gilt yields to move in a narrow range. We expect the yield curve to be steeper as the curve starts reflecting the market's acknowledgement that long bond yields offer limited upside in the coming months.

The current US-Iraq war and its impact on oil prices could keep inflation high in India. This, coupled with strong local growth, could increase the upward pressure on rates.

An upside or rally in the fixed income markets could, however, be possible if the slow global growth starts affecting India.

Monsoons are also a wildcard. Another interesting change the Indian fixed income market is witnessing is on the currency front.

The exchange rate historically had been a negative for the fixed income markets, as rate hikes by the RBI followed periods of sharp depreciation in the rupee/dollar exchange rate.

This is now a worry of the past and recent developments indicate a reversal in trend. The exchange rate is now stronger; the rupee has appreciated against the dollar in the past year and is expected to stay strong.

Rising reserves have also prompted policy makers to prepay external debt. Unsterilised purchases of forex by the RBI have translated into a sharp increase in domestic liquidity, which should benefit the fixed income markets.

The corporate sector is expected to continue to benefit from soft interest rates as they keep lowering interest costs as both lending rates and corporate bond yields move lower.

The government has also started to restructure their liabilities to benefit from the current level of interest rates.

State governments have already initiated a debt swap scheme where loans of around 13-14 per cent will be swapped by market loans around 7 per cent and small savings collections at a cost of around 8 per cent.

For investors in debt products, they need to align return expectations to current levels as most of the returns would now come from accruals rather than the capital gains seen in most mutual fund investments.

They should also consider hedging their exposures to fixed income products so as to minimise risk from any marginal rise in rates.

Pradeep Dokania is executive vice-president, DSP Merrill Lynch. The views expressed by the author are his own and not that of his company.

Yields set to creep up

M R Madhavan

Let us assess the liquidity scenario and inflation to gauge the behaviour of interest rates in 2003-04.

Liquidity

The main determinants of liquidity are government balances (gross borrowings versus redemption and coupon inflows); credit and deposit growth; and the external balance of payments. 

The central government's gross borrowing programme for the fiscal is budgeted at Rs 1,66,000 crore (Rs 1,660 billion). I estimate the fiscal slippage to be at least Rs 15,000 crore (Rs 150 billion).

In addition, premature repayment of high cost external debt may entail further borrowing of Rs 15,000 crore.

Add to this, the borrowings of state governments (about Rs 30,000 crore or Rs 300 billion, going by this fiscal's numbers), and the total borrowing by the Center and states could well be to the tune of Rs 225,000 crore (Rs 2250 billion). 

The system will see inflows of about Rs 58,000 crore (Rs 580 billion) from redemptions and Rs 65,000 crore (Rs 650 billion) from coupons. So, the government system will need an incremental funding of about Rs 100,000 crore (Rs 1000 billion).

Demand for funds from the private sector will depend on whether economic growth picks momentum in the next few months.

Going by the trend of the last few years, the deposit-credit gap would likely be of the order of Rs 50,000 crore (Rs 500 billion). 

Foreign exchange inflows were key to the excess liquidity conditions seen during the current fiscal. The reserves rose by $20 billion in fiscal 2002-03. The key question is whether a repeat performance is likely in 2003-04. 

The current account will likely generate a surplus of about $4 billion, as exports of infotech enabled services continues to grow. The catch is in the capital account. Resurgent India Bonds, which fall due this August, would entail outflow of about $6 billion (including interest).

Also, the government is likely to continue its programme of premature repayment of high cost debt; the amount in 2002-03 was $3 billion and we could assume a repeat of this amount.

Taking neutral assumptions on other flows, the projection for the balance of payments places net inflow next year at about $5 billion (about Rs 25,000 crore or Rs 250 billion). 

In sum, liquidity would be substantially tighter next year. Of course, the Reserve Bank of India still has a few tools to maintain a loose monetary policy. They can cut CRR by 175 basis points to infuse about Rs 18,000 crore (Rs 180 billion). 

The central bank can also take private placements and purchase government securities to ease liquidity.  Whether they use these tools will be dictated by how inflation pans out.

Inflation

Inflationary pressure has been concentrated in fuel items (latest year-on-year inflation is 7.75 per cent) and primary products (6.15 per cent). 

But prices of manufactures products have also risen by 3.8 per cent, compared with the sub-1 per cent inflation seen a year ago.

If global oil prices ease as the Iraq war winds down, I expect inflation to stabilise in the 4-4.5% band. At this level of inflation, the central bank may not use policy tools aggressively to push down interest rates.

To sum up, liquidity will be tight and inflation would be about 4.4.5 per cent. In this scenario, the 10-year yield is unlikely to stabilise below 6.25 per cent.

The upside will be capped near 7 per cent as the central bank is unlikely to move the LAF (liquidity adjustment facility) corridor unless there are clear signs of a broad economic recovery.

M R Madhavan is Currency & Rates strategist, Bank of America.