Catching the money market off guard on Friday evening, the central bank upped key policy rates?the repo and the reverse repo rates?by 25 basis points to 5% and 3.5%, respectively. The market hadn?t expected the tightening process to begin until end-April. But with inflation nudging double digits and the growth in factory output sustaining, there is little doubt that key policy rates will be raised by about 125 basis points by March next year. In fact, at least four banks hiked deposit rates in February, by anywhere between 25 and 100 basis points across various maturities?anticipating that money would become dearer.
Given the abundance of liquidity in the Indian money market for more than 6-8 months now?around Rs 70,000 crore has been lying with RBI in reverse repo?the yield curve in India is the steepest in more than a decade. Short-term rates have also been extremely low because banks do face some competition from mutual funds that have an edge given the tax benefits they attract. Near-term rates had increased somewhat after the hike in the CRR by 75 basis points in two phases in January and should move up further as key policy rates are now increased. From the perspective of banks, this is not a problem and, in fact, helps their net interest margins.
However, over the last two months, long bond yields have moved up meaningfully, breaching the 8% mark on a couple of occasions. The market believed that the central bank wasn?t raising rates warranted by the buildup of inflationary expectations as well as robust industrial growth. To that extent, the move is welcome because as the central bank itself explained, ?given the lags in monetary policy, it is better to respond in a timely manner, even if it is outside the scheduled policy reviews than take stronger measures at a later stage when inflationary expectations have accentuated.?
With RBI now having signalled the end of cheap money, inflationary expectations could get tempered, thereby capping the yield on the 10-year benchmark. That would be good for banks because they would take a smaller hit on the portfolio of securities that needs to be marked-to-market. But the more likely scenario is that yields could inch up to 8.5%. Much would hinge on how government borrowing is paced, how much of it is frontloaded, whether a fair share is at the shorter end and how much is mopped up through floaters.
In the immediate term, the ample liquidity in the system should be adequate to satisfy the demand for credit from both individual and corporate borrowers?with the growth in non-food credit still under 16%. Deposits are growing at a fairly healthy 16% and the momentum should pick up if rates are upped. If push comes to shove, RBI always has the option of allowing greater participation by foreign institutional investors in the government debt market. As it is, with India?s sovereign rating having been upgraded, the risk appetite for Indian paper will improve and banks and companies can now pick up money at somewhat better rates. Flows into the capital market are expected to match the $17 billion that came in last year.
In fact, no bank is looking to up lending rates right now and the market is actually penciling in a small increase in the CRR in April once the shrinkage in money, owing to the advance tax payments, is normalised through government spending. Indeed, credit growth is expected to pick up meaningfully only in the second half of the year. While some banks have upped rates for auto loans, the rates in themselves aren?t really high and this is more of a reversion to the mean rate prevailing before the global financial meltdown in late 2008. Even after a hike, policy rates are low by historical standards. As of now, there?s little danger of either retail or corporate borrowers shying away from borrowing or scaling back their operations. That?s because confidence has clearly returned and the factory output numbers are more encouraging than ever at 17.6% for December and 16.7% for January. Anecdotal evidence suggests that companies are hiring once again and consumers are spending.
The only area of some concern is capital expenditure. Bankers point out that companies are cautious about going ahead with large projects, possibly because of the state of the global economy where it appears that the recovery could be delayed. Sovereign crises in countries such as Greece haven?t been comforting either. The other risk to growth is higher oil prices. It?s true that the equation between growth, inflation and interest rates needs to be managed and that could be tricky. And banks will have to be careful while setting their base rates in July, given that they cannot lend below the floor. But, as of now, there?s little cause to worry.
shobhana.subramanian@expressindia.com