Interest rates likely to remain high

February 6, 2014

(Rajiv Deep Bajaj is the Vice Chairman and Managing Director of Bajaj Capital Ltd. The views expressed in this column are his own and do not represent those of Thomson Reuters)

The Reserve Bank of India (RBI) raised its benchmark repo rate by 25 basis points to 8 percent at its policy review meet in January. The reverse repo rate rose to 7 percent while the bank rate and marginal standing facility rate climbed to 9 percent. This is the third hike in repo rate since RBI Governor Raghuram Rajan assumed office in early September.

The primary reason for the hike, as stated by the RBI, has been high retail food inflation and a recovery in core WPI inflation. However, fears over further tapering by the U.S. Federal Reserve could have forced the hike as well.

If one looks at inflation data, one would find that inflation had in fact moderated in December as compared to the previous month. Hence, if the RBI paused in the mid-December policy meet, there was less reason (purely from inflation data) for it to raise rates in January.

However, core inflation (both retail and wholesale) remained steady and is looking to rise after bottoming out in June 2013. Core CPI inflation was at 8 percent in December, about 0.4 percent higher than in June. On the other hand, core WPI was at 2.75 percent, half a percent higher than in June. This seems to be a direct result of the sharp fall in currency starting in July, which increased costs for manufacturers as well as consumers.

The recent run on emerging market currencies across countries such as Argentina, Turkey, Indonesia, South Africa and Brazil could have also forced the RBI to take a pre-emptive measure.

Emerging market currencies had started falling in January this year as fears of further tapering of QE by the U.S. Federal Reserve took hold. Emerging markets with high inflation, current account deficits and fiscal deficits were affected the most.

The Argentine peso saw the worst fall, declining by nearly 20 percent in a month, even as the Central Bank of Argentina raised rates to 25.9 percent. Next in line was the Turkish lira, falling by as much as 8 percent by Jan. 24, before the Turkish central bank increase the one-week lending rate to 10 percent from 4.5 percent. The South African rand slipped by 7.3 percent, despite a hike of 50 basis points by the country’s central bank.

Banks in India are unlikely to follow suit with a hike in their base lending rates anytime soon as the repo rate, even after the increase, remains below rates at which they presently borrow in the interbank money market. The 7-day and 14-day term repo rates hovered at 8.15 percent or above, higher than the repo rate, as did the call money and other rates.

This means, the actual cost of borrowing for banks has not really risen to a great extent. Hence, chances are low that we may see an immediate hike in bank lending rates or loan EMIs.

Even the benchmark 10-year g-sec yields have not reacted much to the rate hike, hovering in the 8.75 percent to 8.85 percent range. This means even investors were not affected much.

For the first time ever, the RBI has set a specific target for CPI inflation. This, combined with a steady core CPI inflation that refuses to ease further, has us worried about the outlook on interest rates. We may not see rates coming down anytime soon, despite growth slowing further.

The very low probability of interest rate cuts in the near future and a very flat yield curve make us bullish on low duration and accrual strategies. The era of cheap and easy money for emerging markets to fund their fiscal profligacy is almost over. Interest rates are thus likely to remain high, longer than any of us was expecting.

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