Are policy makers under the US spell

Updated: Jan 28 2008, 05:31am hrs
The bull run on the equities front appears to have vanished almost overnight. Since the beginning of last week till Thursday, the benchmark equity index, Sensex, has lost nearly 1,800 points in a market that fluctuated wildly beyond 2,000 points in intra day trades at least on two consecutive days.

Foreign institutional investors (FIIs), one of the chief drivers of the Indian bull phase, were big time equity and debt sellers during the week. In the four days since January 18, they sold over Rs 10,500 crore in equities and Rs 934 crore of debt.

When the Federal Reserve cut rates by 75 basis points to 3.5% last Tuesday, in what officials claimed an emergency measure, domestic fund managers began worrying over the widening differential between the Fed funds and the lesser comparable benchmark rate at homethe 7.75% repo rate of the Reserve Bank of India (RBI).

Also, the India growth story took a new turn with the growth rate now being speculated to move downward to 8% from the earlier 9% forecast.

Unlike the September, 2007 Fed cut of 50 bps to 4.5% that led to a massive spurt in foreign capital inflows, the recent cut is not likely to entail a similar situation. Perhaps the Fed cut is good news for the RBI, that for long, has faced the horrendous task of intervening to tackle a fast appreciating rupee and subsequently sterlising the rupee infusion thereof.

The Fed cut this time has been borne out of a crisis where many top US banks have eroded their capital base as a result of their over-exposure to bad asset lending, namely mortgage home loans to subprime borrowers. Besides, there has been a severe credit crunch since August 2007 there as a result of mortgage defaults that made interbank borrowing costs expensive and slowed down the US economy.

Back home, while the capital inflows through the FII route being unlikely to spurt significantly as a consequence to the recent Fed move, the concern remains of banks and corporates increasing their overseas borrowings to take advantage of the rate differential and come back with the money. Though there have been restrictions imposed by the RBI on such corporate repatriations, banks do stand to gain. Corporates could find some way to circumvent these.

The market always finds new ways of creating liquidity that could be still within the ambit of the regulator's rules.

For example, till recently, when fresh IPOs hit the market almost every other day, corporates especially non-banking finance companies engaged in the business of providing margin-funding to companies and high net worth individuals applicants (of equity IPOs) have been big borrowers through the commercial paper (CP) route.

These NBFCs had another tie-up with mutual funds that lent them money at rates which are as high as 10%. Three-month borrowing rates of triple `A corporates rose from 7.5-7.6% level during the first week of October, 2007 to 8.75-9.4% around the fortnight beginning mid-December, the market witness a sudden jump of 180 basis points.

Since the beginning of the year 2007 till December last, the money raised in CPs, of varying maturities and up to a maximum tenor of one year, stood at Rs 9,325 crore.

The entire cycle was a watertight, back-to-back arrangement between corporates, high net worth individuals applying for IPOs, their financiers, the non-banking finance companies (NBFCs) and the lending organisations namely, mutual funds. This arrangement also explains the rate inconsistencies of identical rated issues raised in or around the same period. The rate differential, as can be seen in the month of December 2007 was as wide as 80 to 100 basis points for two similar triple A rated papers.

The returns for IPO applicants ranged between 25% and 30% on listing, hence it was worthwhile to tap the CP market for additional resources that had ready-made takers (lenders) like mutual funds who earned interest rates as high as 10%.

This should explain why primary equity issues that hit the market last year, got oversubscribed many times the issue size. Between November 2007 and December 2007 the IPO raised was around Rs 8,000 crore to Rs 10,000 crore.

Now, the worry for bankers is that of liquidity tightness and some move is expected from the RBI towards the policy rates. Bank credit has already started showing signs of a pick up. This could entail a 25 to 50 bps reduction in bank cash reserve ratio from the present level of 7.5%. Besides, the RBI would need to move towards ensuring the interest rate differential between the US and India remains stable at the pre-Fed cut level, if not narrower.

With global crude oil future ( March) prices coming off highs and falling by $2.2 on Wednesday to $86.99, the RBI is undoubtedly at ease on the inflation front. Besides, the FII inflows is again not likely to push up the rupee as it appears they are more than likely to either exit or have limited exposures in domestic bourses no matter what opportunites emerging economies offer.

Therefore, the RBI, perhaps, is in a comfortable zone to test the waters and bring down the corridor rate differential by at least 25 bps, if not 50 bps.

With the government pressure to bring about a feel-good factor, there is more likelihood of the RBI tinkering with corridor differential that is currently at 1.75%.

Having said so, another pointer towards lowering interest rates is the government bond benchmark rate, which has, in a weeks time, lost 14 bps. The benchmark ten-year bond, 7.99% of 2017, has dropped from 7.54% to 7.4% on Thursday. This primarily because of the rising demand for government bonds by financial institutions after the recent spate of events that has made equities riskier. Domestic financial institutions, mutual funds, banks and insurance companies have already begun shuffling their portfolios, their weightages are more toward risk-free government bonds. So is the time ripe to infuse some liquidity