The Hindu Business Line : An ‘interest’ing climb down ahead

A move to a lower interest rate regime appears increasingly certain in the near term. But it may be gradual. Other macro factors such as the level of global interest rates and inflation expectations also would have to be reckoned with in structuring an interest rates stance, says T. B. KAPALI.

The key question engaging the minds of all economic agents now is: Is the stage set for an immediate softening of interest rates or is it premature to make this call now? The Reserve Bank of India’s upcoming quarterly Monetary Policy Review, on July 31, assumes critical significance in this context. Will the RBI bless the incipient signs of interest rate softening or will it continue to exercise caution and wait for some more time to formalise a move down?

Leading financial players have gone on record that rates have peaked for the current interest rates cycle and that the RBI would acknowledge this appropriately in its Policy Review. Various market rates — ranging from short-term treasury bills to long-term government securities — have come down in the recent past indicating the market readying for a general move down in interest rates. There have been some moves on the most critical component of the overall interest rates universe also — bank interest rates both on the liabilities and assets sides. These are yet tentative and have not assumed the momentum necessary for a general softening in rates.

Data provides signals

Indeed financial markets and macro-economic data provide signals that rates may have peaked for the current interest rate cycle. Yet, it is also probable that the RBI will not formalise the peaking (and the subsequent logical softening) in its forthcoming Policy Review. Therefore, if interest rates do come down it may be a suo motu market act. In other words, the RBI could hold steady, meaning no change in its key money market intervention rates — the repo and reverse repo &# 8212; as also the reserve ratios.

In the absence of price signalling from the central bank, market players may have to take the lead in structuring an interest rates stance for the immediate future. The interest rates view and the actual stance of industry leaders would be critical in this context.

What lends support to this view is the fact that the prevailing softness in the inter-bank call money market (one of the indicators of other interest rates) appears to be more due to a general slowdown in lending activity in the commercial banking system rather than reserve money creation by the RBI. Foreign exchange reserves accumulation (the main source of reserve money and consequently inter-bank liquidity) has slowed considerably in recent months. Between mid-April and end-June, the RBI’s foreign currency assets went up only by around $4.5 billion; a good part of it was also due to the valuation effects following the dollar’s sharp fall against the euro and the pound in the period.

In the two-three months period up to mid-April, the RBI’s foreign currency assets had gone up by $23-25 billion. The dollar also was more range-bound against the major currencies in that period and, therefore, much of the increase in reserves reflected hard currency accumulation by the RBI.

Operational and technical factors such as the RBI having a ceiling of Rs 3000 crore on the quantum of money-market surpluses it will absorb in its daily LAF (liquidity adjustment facility) operations also are playing a part in keeping money market rates ultra soft, below 1 per cent.

With the inflation also showing signs of moderating (though there has been a slight up-tick again in recent weeks), the RBI, by not budging, could squarely place the ball in the court of financial market participants to take a stance on interest rates.

Proximate driver

The proximate driver of the softening of interest rates view is the level of daily money market surpluses. This broadly indicates a surfeit of liquidity in the system. If liquidity stringency is the primary driver for rates to move up, then a surfeit of liquidity should automatically mean rates coming down.

As the Table shows, the money market surplus in the past month and a half has been very high; in one week, upwards of Rs 1,00,000 crore was sloshing in the banking system. (But it must be pointed out that the money market has swung between the deficit and surplus mode the past six-seven months and only in the past month and a half has it been consistently in surplus.

To that extent, there is a certain weakness in the move towards lower interest rates.)

This level of liquidity can be brought down in two ways. It should either find deployment in various assets at the prevailing level of interest rates. Or the liquidity should be drained through a reduction in rates on the borrowing side which will then spill over to the lending side also.

There has been a noticeable slowing of credit expansion the past several weeks. Year-on-year credit growth, which was as high as 29.50 per cent in mid-March, was down to around 23 per cent at end-June. The related monetary aggregate M3 also is growing at slightly slowly, of around 21 per cent currently against 22 per cent at end-March.

Therefore, it is apparent that the previous rounds of rate hikes have had the effect of slowing credit demand and subsequently growth in the system.

The incentive of higher rates on the savings side, though, continues to keep broadly unchanged the liabilities growth in the banking system; deposits were growing at close to 24 per cent year-on-year end June, almost at the same level as seen in end-March.

Determinants of interest rates

At the short end of the interest rates spectrum, the level of money market liquidity (and expectations about it) critically affects interest rates.

Therefore, given the current level of liquidity in the money market and the expected liquidity scenario, there is a case for a drop in short-term rates.

The medium/ long-end of the interest rate curve is fundamentally influenced by the prevailing level of inflation and, more importantly, expectationsabout inflation. It is here that the recent moves in the inflation numbers assume significance.

There has been a noticeable decline in prices at the wholesale level the past six months. Prices which were rising by as much as 6.75 per cent Y-o-Y early February are now growing at a much lower rate of around 4.30 per cent.

But there has been volatility in this time series and that is what suggests that the RBI may not explicitly indicate lower interest rates in its Policy Review.

The softening in wholesale prices has to be so entrenched in the system that not only the prevailing level of inflation but also inflation expectations get anchored.

Viewed from this perspective, it would appear that the current long-term bond yields at around 7.80/7.85 per cent represent the market running slightly ahead of itself in pricing softening inflation expectations.

Overall, a move to a lower interest rate regime appears increasingly certain in the near term. But it may yet be gradual.

Other macro factors such as the level of global interest rates and expectations about energy prices (oil around $72/73) also would have to be reckoned with in structuring an interest rates stance.

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