Rising rates and unspoken fears

Sucheta Dalal 26 Feb 2007

The government has obviously hit the panic button over inflation rising to 6.73%, despite its many efforts. Last week, the government set up a special price monitoring cell in the cabinet secretariat and the Prime Minister wrote to all Chief Ministers seeking their help to keep prices in check. That these moves have been widely reported around the world indicates how closely India’s economy, as well as its capital and commodity markets are being watched. Any drastic decision to hike interest rates and slow down the economy in the hope of curbing inflation is bound to impact portfolio flows to India, which would affect several sectors of the economy. Since India is one of the world’s largest producers and consumers/importers of a wide swathe of commodities, our domestic prices and demand-supply factors have an impact on international price trends.

A few weeks ago, the Prime Minister personally threw open the inflation issue to public discussion, making it clear that he wanted views and feedback from all constituencies. It triggered a massive media debate over controlling inflation at the cost of economic growth. There were equally strong arguments on both sides. However, two crucial stakeholders stayed out of the debate—industrialists and bankers.

Industry is probably feeling complacent about the liquidity situation. Globally, liquidity is not a problem. There is plenty of money waiting and willing to be lent to Indian companies at excellent rates today. The capital market has, however, turned distinctly jittery, but since this is just a one-week phenomenon, it is probably too early to signify an important turning point.

But bankers are not so sanguine. They are seriously worried that any further increase in interest rates will cause a severe economic setback and that the implications of such an action are not fully understood by policymakers. There are already indications of the speed with which interest rates could rise in the bidding for short-term deposits. Last week, a 100-day fixed deposit by Gas Authority of India Ltd received seven bids from banks, all willing to pay over 10% — they included State Bank of Patiala, which offered 10.51%, Bank of Baroda (10.26%), Union Bank (10.20%), State Bank of Hyderabad (10.03%) and IDBI Bank, Allahabad Bank and ICICI Bank offering 10% while Punjab National Bank offered 9.95% and HDFC Bank offered 9.4%. ICICI Bank reportedly offered 10.10% for a 30-day deposit of Rs 150 crore to Unitech and there is talk of a Rs 1,000 crore deposit having been snapped up for 11%. If this is the situation today, then another hike will cause interest rates to go haywire.

The Indian economy is bubbling along based on increased consumption, thanks to higher earnings as well as the availability of easy personal loans and finance for everything from white goods to family holidays. That will change. High interest rates will slow down fresh borrowing, while delinquencies on existing personal loans could increase if money has gone into the stock market, which was exceedingly nervous last week. On the mortgage front, borrowers are already sore at the repeated increase in interest rates. So far, there were a few mitigating factors such as rising realty prices and increased household incomes. Lenders also had some cushion to avoid hiking equated monthly instalments (EMI) across-the-board, because the average borrowing age has dropped sharply from 40-plus to the late 20s. Another interest rate hike could force banks to hike EMIs as well.

Rates could rise. There are already indications of the speed with which interest rates could rise in the bidding for short-term deposits. Last week, a 100-day fixed deposit by GAIL received seven bids from banks, all willing to pay over 10%

The trend in realty company shares, which have dropped anywhere between 20-35% in the last three weeks, suggests that this bubble is starting to lose air. A sure sign of rising panic is the fact that bankers were suddenly talking about the downgrade of a personal loan pool of a private bank by Crisil. This had happened over a month ago, and the rating agency insists that it does not signal a trend so far.

If the realty bubble bursts and the capital market goes into a deep correction, the impact is bound to slow down the growth of a wide cross-section of manufacturing companies. This, in turn, will have a domino effect on foreign portfolio inflows. While all this pain may indeed curb inflation, will it cool public anger over the rise in prices of staples such as rice, dal, wheat, milk, onions and potatoes? Their prices have risen anywhere between 30% to 200%, so the drop of a couple of percentage points in the overall inflation rate is hardly likely to reduce these prices substantially. Since the government’s panic about rising prices is heightened by forthcoming state elections, it would make far better sense to figure out ways of supplying these food essentials at controlled prices to lower income groups. While economists may sneer at such an inelegant solution, it is perhaps better than the alternative scenario projected by worried bankers, traders and select industrialists on condition of anonymity. Ironically, nobody wants to speak publicly about this scary picture for fear of offending either the central bank or the finance ministry.

Instead, they prefer to start preparing for tougher times and even a possible repeat of the debilitating slow down of the latter 1990s.

At a time when India’s confidence level is riding higher, does it make sense to force the country into a period of needless pain—especially when the surge in agricultural commodity prices, particularly in oilseeds and grain, is a global phenomenon?

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