The Hindu Business Line : Rise in interest rates

Therefore, when the CII President, said some time back that the Reserve Bank of India's serial hikes in interest rates (over the past couple of years) caused disquiet in industry circles, it was a break with the past.

It is not clear what prompted the industry representative to make such a comment immediately after the RBI's last package of monetary tightening measures of March 30.

That is, one is not sure if the comments were just a reaction to the totally unexpected nature of the March 30 move or whether it was also motivated by the strain that repeated interest rate hikes puts on corporate financials.

Weak correlation

Whatever it may be, the stock market does not seem to have considered the general increase in the cost of borrowings in the past couple of years as a serious drag on the financials of companies constituting it.

In the circumstances, stock market returns have been only weakly correlated with the general up-trend in interest rates. An analysis of the movements in the inter-bank call money rate (used as a proxy for the general level of interest rates) and that in the market indices over the three years from April 2004 points to such an inference.

Returns on both the BSE Sensex and the NSE Nifty have a low correlation of around -0.14/ -0.15, with the call money rate in the above period.

Returns on the broader CNX Mid-cap index also do not seem to be strongly related with the moves in interest rates, as this measure is also quite low at - 0.15.

The usual t-test also confirms that this numerical estimate of the relationship between call rates/stock market returns is statistically not significant at the 1 per cent level of significance.

The correlation is negative, showing the inverse relationship between interest rates and corporate profitability. But its low level shows that there are several other factors now impinging on corporate profitability and not merely local interest rates.

Not filtering down to profits

The low correlation, of course, could also be on account of what economists call "the inefficiencies in the monetary policy transmission process".

That is, interest rate moves — either up or down — of the central bank not getting fully passed on to the entire range of borrowers, lenders, instruments and maturities in the period envisaged.

Even factoring such possible inefficiencies into the transmission process in the Indian interest rate/credit markets, it is not clear if interest rates moves will begin to influence or determine corporate profitability patterns — if not for the whole of Corporate India, at least that part which is listed and can raise public capital — significantly any time soon.

For one, capital-raising options are now manifold for Indian companies.

Indian companies are now not only well-established and known names in the overseas markets for raising risk capital; the India risk appetite is now high enough for large amounts of debt capital to be raised in the international markets, even by second-tier companies.

The RBI's statistics show that as much as $25 billion — around Rs 1,00,000 crore — was contracted as External Commercial Borrowings in FY 2007 alone.

While certainly an activity to be monitored closely for its implications on the level of overall external debt, its maturity and the currency/liquidity risks embedded in it, the overseas borrowings of Indian companies seem to be providing good relief for corporate financials during the current upward interest rates cycle.

This certainly does not detract from the importance of the bank-lending channel in overall corporate financing strategies.

Indeed, as the RBI's statistics show, bank borrowings have accounted, on an average, for around 12-13 per cent of the total sources of funds for Indian corporates in the past decade. The share of equity capital has been slightly lower, at 9-10 per cent.

Given the consistent share of bank borrowings in overall funding, one would have expected a greater impact on corporate financials/profitability and, therefore, stock market valuations, on account of rising interest rates.

But, as pointed out above, the inefficiencies in the monetary policy transmission process are possibly mitigating bank financing cost pressures.

Also, plausibly providing relief is the high level of sub- or below-PLR lending in the banking sector.

Again, RBI statistics show that between September 2004 and March 2007, public sector banks' sub-PLR lending grew from 33 per cent of total lending to as much as 75 per cent of all loans outstanding. It is not difficult to understand that the major beneficiaries of this splurge in sub-PLR lending would have been the top and middle-tier companies.

It is possible that the stock market is pricing in all these features of the corporate financing scene.

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