With the Reserve Bank of India (RBI) not turning too hawkish, bond markets celebrated with a small rally on Tuesday. But they know fully well that this will be short-lived because at the very least interest rates are expected to be hiked by about 75 basis points between now and March and by about 125 basis points by mid-2011.
There were many who were expecting a 50 basis points hike in the key policy rates and an addition increase of around 25 basis poinst in the cash reserve ratio. But as the RBI governor has said, he would rather cross the river by feeling the stones. For sure, it was somewhat surprising that governor Duvvuri Subbarao chose not to tighten money a little more. In fact, since liquidity continues to be abundant and demand isn?t exactly overwhelming, banks wouldn?t have increased rates.
The competition today for some products such as mortgages is so fierce that some players are trying to tempt customers with low rates in the first two or three years. While non-food credit growth for 2009-10 did hit the RBI?s target of 16% and even crossed it slightly, much of it could have been short-term lending at the end of the year.
But Subbarao perhaps doesn?t want to scare industry. He?s probably hoping that inflation may peak soon since there are some economists who believe it will peak by June. Also, while industrial growth is undoubtedly strong at 16.7% in January and 15.1% in February, capital expenditure isn?t picking up at the pace it should. It?s true that orders have been pouring into engineering firms such as Larsen and Toubro but not too many projects have got off the ground. Indeed, there are companies that are waiting to get a clearer picture of what?s happening overseas before moving ahead on capital expenditure plans. The governor remains anxious about the government?s borrowing which is 36% more this year compared with last year; he has hinted there could be some pressure on interest rates.
And there?s always the worry of the monsoon; if it turns out to be less than normal, rural demand would be impacted, as the governor himself has said. Of course, food prices could soar again calling for more tightening.
Now, there are those like HSBC economist Robert Prior Wandesforde who says there could be as much as 50 basis points hike between now and the next meeting at the end of July; in all Wandesforde?s expecting a 200 basis point hike by mid-2011 of which 50 basis points has happened. Wandesforde points out that even after Tuesday?s tightening, repo and reverse repo rates are about 200 basis points below their long term average and of course even the RBI recognises that real rates are negative. In the near term though both lending rates and deposit rates are likely to remain where they are and the yield curve would continue to remain steep for some time; perhaps the increases may be visible when bankers switch to the base rate system in July. By then rates would certainly have moved up. Until then, unless demand suddenly perks up, bankers will need to compete hard to grow their loan books, even on the relatively low base of 2009-10.