Rate hikes may be over, but money will be costly till mid-2012

The Reserve Bank of India (RBI), after the repo rate hike of 25 basis points (0.25 percent) in the October 2011 policy review, suggested that it will not have to raise policy rates further in December 2011 and in policy reviews thereafter.

Inflation, as per the RBI, is likely to trend down from over 9 percent levels from December 2011 onwards to touch 7 percent in March 2012 and trend down further in April 2012. However, it is too early to cheer on the direction of interest rates in the near term, as there are many factors that will keep rates from coming off.

High interest rates will keep yields on government and corporate bonds at higher levels. Investors should use this opportunity to build positions in long-duration fixed income products and bank stocks that will benefit from rates coming off in the beginning of fiscal 2012-13.

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The factors that will prevent rates from coming off in the near term are: a) RBI is still in an anti-inflation mode; b) savings rate deregulation will push up borrowing costs for banks; c) government finances are still weak and its borrowing will place pressure on bond yields; and d) liquidity in the system will not ease soon.

The RBI, while signalling an expected downward trend in inflation is still wary of any upward surprises in inflationary expectations in the form of global commodity prices, inadequate pass-through of domestic administered prices, potential rise in domestic power costs and expected rise in food prices. It will maintain a tight monetary policy till March 2012 until it has seen a clear downward trend in inflation expectations.

The complete deregulation of savings deposit rates is reformist and will eventually make the banking system much more productive. However, in the short-term bank borrowing costs are likely to go up by 1-2 percent as per various estimates. The higher borrowing costs for banks will push up costs across the system as banks try and pass on the higher costs to maintain margins.

The government is struggling to meet its budget estimates on the revenue and expenditure side. The RBI estimates that government subsidies on fuel could slip to 0.74-0.87 percent of GDP from budgeted levels of 0.26 percent of GDP. Revenue loss from duty cuts on fuel could go up to 0.29 percent of GDP. The government has raised less than 5 percent of the disinvestment target of Rs 40,000 crore, leading to further pressure on its finances.

A slowdown in economic growth, which RBI estimates at 7.6 percent for 2011-12 against initial estimates of 8 percent, will bring down tax collections, leading to more pressure on the government’s fiscal deficit. The government has raised its borrowing for 2011-12 by Rs 53,000 crore and any more upward revisions in its borrowing number will push up bond yields.

Liquidity, as measured by bids for repo (the rate at which RBI lends money to the system), is in deficit by around Rs 62,000 crore on a daily average basis as of week ended 21 October 2011. Liquidity has been in deficit since June 2010 and is unlikely to ease significantly going forward due to festive season demand for cash and due to a sharp depreciation in the rupee (rupee has fallen by over 10 percent in the last couple of months).

A weak rupee signifies outflow of US dollars from the system, leading to liquidity being sucked out of the system.

Ten-year government bond yields are trading at around 8.7 percent levels, up by 90 basis points (0.9 percent) in the fiscal year to date and the yield is unlikely to come off soon in the face of higher government bond supply. Benchmark 10-year corporate bond yields at 9.75 percent is higher up 60 bps (0.6 percent) fiscal year to date while money market rates (securities of less than 365 days maturity) have gone up by over 125 bps (1.25 percent) in the fiscal year to date.

Corporate bond yields and money market securities yields are unlikely to come off soon on the back of tight liquidity conditions.

The near-term direction of rates is flat to higher but the longer term direction of interest rates is positive given expectations of inflation coming off next fiscal and prospects of the RBI slowly turning around its policy stance on the back of slowing economic growth and falling inflation expectations.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.