Unexpected outcomes of interest rate cycle

Last December, in this column one had written about how interest rates changes did not always bring about textbook outcomes. Short-term interest rates declined precipitately in the US, from 6.5% in early 2001 to 1-1.25% for most of 2003 and 2004. The stock of commercial paper (CP) after peaking at $1,606 billion in December 2000 has steadily fallen to $1,357 bn today. More pertinently, CP outstanding by non-financial companies is as much as 57% lower than what it had been in December 2000. And, this decline in CP issuance was not offset by higher bank lending. In fact, bank loans to the commercial and industrial (C&I) sector fell by 17% over the past four years, from $1,077 bn to $895 bn.

Businesses borrow when they see opportunity to expand operations and launch new products. When things turn down, they try cutting costs and reduce inventory and receivables. Hence, working capital generates, rather than consumes cash, and borrowings decline. Over the past few years in the US, it has been consumers and homeowners who have been absorbing bank liquidity.

So does interest rate changes have any effect on a business decision to invest? The answer has to be ?yes?, but only under that often overlooked caveat ? ?other things remaining constant?. So, we need to look at what those other things are. A decision to invest involves a commitment for five, ten or even more number of years. For that is how long the capital being invested is expected to provide returns. Everybody is aware that over this kind of time period ? that is, the life cycle of the project in which the investment is being made ? there is going to be several interest rate cycles. While, it would be advantageous to be able to achieve financial closure at a point that corresponds to the lower end of the interest rate cycle, it is indeed a bargain, but a transient one. Most of the debt capital would be subject to re-pricing in any case over the life cycle of a project. What is therefore most important is what gives life to the business idea embodied in the project. It is the sense of opportunity and spirit of confidence; an environment of economic growth, positive policymaking and past success that infuses life into the investment idea.

So, as the economy began to rebound sometime in the middle of 2002, part of the preconditions were being met. The ongoing tensions with Pakistan, however, clouded things over. In the next year, the process of re-looking at investment ideas must have begun, but with the elections due, the bigger decisions were held over till after the new government was in place. Not surprisingly, credit offtake by the C&I sector started picking up in 2002-03 and this is the third year running that offtake is strong. The pace in 2004-05 is quite scorching. In the first quarter (April-June) normally credit growth (with respect to the previous year-end) is negative. While, ever since 2002-03 this number has been in positive territory, in 2004-05, the first quarter saw non-food credit grow by a spectacular Rs 35,000 crore, and then surge in the second (July-Sept) quarter by another Rs 57,500 crore. In the month of October non-food credit rose by another Rs 18,600 crore (after adjusting for the impact of conversion of IDBI to a bank). On a year-on-year basis, non-food credit is now expanding at an annual rate of 26%.

From the demand-side, one can understand the pick up in credit, given the magnitude of the investment cycle that is beginning to kick in. But how about the supply-side, are there any explanations there? In the past few years as liquidity has risen by monetisation of a part of foreign capital inflows, interest rates have declined dramatically ? or more accurately, yields on government securities, cost of short-term money and rates linked to these benchmark yields have all dropped ? and by a large magnitude. At the same time, there was a large supply of government securities. First, from fresh issuance by central and state governments towards financing of the fiscal deficit which remained at 10% of GDP; second, from open market sale of government securities made by RBI, to partially sterilise capital inflows, in 2002-03 and 2003-04. State-owned banks saw this as a good opportunity to make money and they did so by deploying an ever-increasing part of their available funds into picking up government securities, in the confident expectations that a purchase made today would be in-the-money tomorrow.

As the interest rate cycle began to turn worldwide, foreign and private sector banks began to cut their exposure to government securities and reduce the duration (years of residual maturity) of their treasury stock. Public sector banks continued to be buyers of gilts. As the yield on the benchmark 10-year government security rose to 6.7% through last summer, state-owned banks saw much of their vaunted ?unrealised? gains on their bond portfolios evaporate. The RBI provided a window to cap any losses by permitting transfer of bonds into the held-to-maturity category, but not many banks availed themselves of the opportunity. In the interim, the yield on 10-year paper rose to 7.2%.

Unlike bonds, loans do not depreciate; that is they do not have to be marked to market, if the interest rate rises to above what is being charged on that loan. The rush of credit from the supply-side surely has this most obvious of explanations. With bonds souring in the mouth, loans provide the only salvation ? for now and indeed for some time to come. Government may as a result find selling the balance of its bond programme for the year that much more costly. This situation may last for a while, and perhaps government ought to examine the option of tapping external capital markets, perhaps those in the neighbourhood, if not much further away. The prescription given to Indian companies to borrow overseas, may be just as usefully be adopted by the doctor.

The author is economic advisor to ICRA