Whither interest rates

Updated: Dec 31 2006, 06:41am hrs
Interest rates seem to be grabbing attention among all critical indicators. The debt market, where it has a direct impact on returns, is watching the emerging scenario with bated breath. The stock markets, where interest rates make their presence felt by impacting liquidity and corporate earnings, is also watching the plot thicken. All eyes are on the rate. So what do the rates hold in 2007


The most common indicator to interest rate in the country is the benchmark prime lending rate (PLR) of the banks. Theoretically, it is the rate at which a bank lends money to its prime customers. But because of the bargaining power of large borrowers, banks have resorted to even sub-PLR lending to entities with huge credit demand. Banks are now increasingly under pressure to look for avenues to shore-up their deposits and increase their margin and profitability. The CRR hike on December 8 has further compounded their problem. After the recent hike in the CRR, we have seen a spurt in the PLR hike by banks. ICICI Bank, SBI Bank, HDFC Bank, Punjab National Bank, UTI Bank etc have all raised their PLR.

Analysts feel the monetary tightening by the central bank will continue in the last quarter of this fiscal because of strong credit growth. This will further build pressure on the margins of the banks. There is still strong credit growth in the economy and in order to protect their margins banks have to resort to hike in lending rates, said Vishal Goyal from Edelweiss.

Liquidity in the market

Liquidity as measured by the amount of money injected into or absorbed from the financial system by the RBI under its liquidity facility adjustments (LAF) has seen swings both ways. For the first three months, RBI was injecting money into the market, but this changed from April.

Forex market

There is a direct relation between liquidity in the banking system and foreign exchange market. Any dollar buying by the RBI directly or indirectly increases money supply into the system. Intervention of any kind adds to the supply of rupees in the domestic market. The central bank intervenes in the forex market to protect the rupee's export competitiveness against other currencies or curb volatility. In the present context where RBI is following monetary tightening measures, any intervention will effectively lessen its stated purpose.

Call rate

After hovering in the range of 6.00-6.10 for most part of the year, the call rate has gone up to 13.00% on December 27, 2006. This is a six-year high. Previously, during most parts of August 2000, call rates hovered around 14% due to liquidity tightening measures necessitated by the forex market uncertainty.

RBI's observation

In its mid-term review in October; the central bank had increased its projection for the gross domestic product (GDP) growth at 8% from its previous projection at 7.50-8.00%. It also said that monetary and credit growth is expected to be higher than the initial projections and warranted caution. During the current year there has been too much tinkering with various rates by the Reserve Bank of India. As of now, the central has hiked the repo rate, the rate at which RBI lends money to the commercial banks for short duration, by 150 basis points. After a long period of time, the gap between repo and reverse repo has breached past 100 basis points. Recently, the CRR was also hiked by 50 basis points in two phases of 25 basis points each. This has resulted into further drying up of the liquidity in the market.