June 05, 2013

Rising Interest Rates In Times Of Inflation

- Sawant Singh, Partner [ Phoenix Legal ]
- Hemant Krishna V, Associate [ Phoenix Legal ]

Sawant Singh & Hemant Krishna V

The monetary policy for the first quarter of 2011-2012, released by the Reserve Bank, notes that inflation continues to be India's dominant macroeconomic concern.

The wholesale price index inflation rate remained stubbornly close to double digits through the first quarter of 2011-2012. Food prices climbed to a four-and-half month high of 9.90 per cent for the last week of July. An array of economic theories notwithstanding, the scale and persistence of inflation has teased everyone, from the common man to the policy-makers.

Starting March 2010, the Reserve Bank has increased the key policy rates a staggering 11 times in order to contract demand and bring down inflation. In this column, we dissect the impact of successive interest rate hikes on certain key sectors of the Indian economy and revisit the rationale for hiking rates.

Banking on Thin Ice

Interest-rate sensitive stocks are, generally speaking, stocks of two kinds of companies: first, companies that have large loans on their books and secondly, companies whose products are bought by customers on borrowing. Rate-sensitive stocks almost immediately take a hit upon a hike in the interest rate.The recent hike in interest rate caused bank and auto stocks to plunge to new lows as personal and corporate loans are bound to become costlier.

While it would be hard to argue against volatile investor sentiments in the aftermath of an interest rate hike, knee-jerk reaction to a hike may not always be warranted in case of bank stocks. When there is an increase in the interest rate, banks usually increase lending rates as well as the deposit rates. Relatively speaking, the increase in deposit rates is usually much less than the increase in lending rates, which allows the bank to maintain its profit differential even in times of crisis, provided that the fundamentals of the bank are robust. But back-to-back interest rate hikes coupled with an increasing volume of non-performing assets and bad debts are putting a strain on bank balance sheets.

Landing in Real Trouble

In general, an interest rate hike slows down the economy as higher cost of funds adversely affects economic activity. The Reserve Bank's latest increase in interest rate has led to furrowed brows especially in the real estate sector.

The real estate sector had already been reeling under the lack of credit from lending institutions and a further increase in interest rate means that developers will be forced to pass on the higher cost of borrowing to the buyers. The corresponding rise in interest rates on home loans by several banks is likely to deter many potential buyers from purchasing property in the near future.

In addition to the interest rate hikes, the Government has recently introduced a draft Land Acquisition Bill, which proposes that, for land to be acquired by the industry compensation of six times the average sale price for similar land in the village or vicinity must be paid to the land owners. All in all, the real estate sector seems to be in for a rough ride ahead.

Diversifying Debt

While the Reserve Bank's stringent policy initiatives have played spoilsport with many rate-sensitive sectors as discussed above, they have revived the interest in debt instruments. With interest rates soaring, the risk appetite amongst investors is shrinking. Needless to say, the yields on debt instruments have gone up considerably.

Against this backdrop, investors would be keen to diversify their debt portfolio by investing in instruments such as gold and silver which have a better outlook for the short to medium terms. Fixed deposits, non-convertible debentures and fixed maturity plans (FMPs) are offering attractive returns.

The rates on fixed deposits have risen almost upto 10 percent in many banks. FMPs are offering returns in the region of 8.5-9 percent after tax. Lowering Growth to Smother Inflation With the year-on-year inflation crossing 9 percent, the pressure is mounting on the government as well as the Reserve Bank to sacrifice growth in order to bring down inflation. The Reserve Bank has recognised that it is imperative both for sustaining growth over the medium term and for increasing the potential growth rate to rein in inflation and hence, the frequent interest rate hikes.

The most recent increase in interest rate has been met with a frown in certain industry circles with the Federation of Indian Chambers of Commerce and Industry (FICCI) describing the Reserve Bank's move as "a very hawkish monetary stand and one which would make the investment environment more difficult." The FICCI fears that with growth slowing down, employment targets will not be achieved and this could generate greater social pressure. However, the Associated Chambers of Commerce and Industry of India feels that the new interest rate environment will moderate inflation and foster price stability which is key to sustained growth and financial stability.

Regardless of industry expectations, for the time being, the Reserve Bank seems to be in no mood to cool off the interest rates. Only recently, the Reserve Bank governor, D. Subbarao made his intentions clear that priority will be given to checking price rise by stating that "high and persistent inflation undermines growth by creating uncertainty for investors and driving inflation expectations".

The Reserve Bank has lowered the country's economic growth projection to 8 percent for the fiscal against the government's estimates of 9 percent. Morgan Stanley, for its part, has been quick to cut India's growth estimates from 7.7 percent to 7.2 percent for the current fiscal on account of the cyclic effect of inflationary pressures, prevalent corruption, high interest rates and poor market sentiment on the overall investment demand.

The Deflation Conundrum

Inflation in India has consistently exceeded the target-zone for the last five years. A high level of inflation over a sustained period of time can damage growth as it affects the visibility of interest rates and prices of the future and creates an atmosphere of uncertainty that is unfriendly to longterm financial planning. Interest rate hike contracts demand in the market and is hence thought of as an antidote to inflation. Riding on this logic, the Reserve Bank has frequently raised interest rates in the last one year.

However, as figures show, inflation has remained stubbornly high and is showing no signs of reducing, leading many to question the wisdom behind the several interest rate hikes witnessed in the last year. The right approach is not to question the hike itself, but to ask whether it is sufficient to contain inflation. The answer is a resounding 'no'.

Supplying Solutions

India's steady if not spectacular economic growth over the last decade has translated into fatter pay-cheques for the organized sector, in particular the corporate sector. The rise of purchasing power of corporate India has spurred consumption further and catapulted commodity prices to new heights. The pinch has been particularly harsh for those in the neighbourhood of the poverty line. External factors such as the rise in global oil and wheat prices have also been at play in mounting inflationary pressures on India.

However, the government's response to this scenario cannot merely be a finger-pointing exercise. Instead, the focus should be on devising a pragmatic strategy to combat inflation on the supplyside including concrete steps towards upgrading India's rural infrastructure, increasing efficiency by encouraging private sector participation and facilitating greater productivity by creating a proper market for agricultural land.

The apex bank too has its task cut out. Besides hiking interest rates, it has to cement its credibility as a body committed to tackle inflation. For this, it will have to prioritise its anti-inflationary role over others, such as nurturing exports and managing government debt.

Ritualistic Response

While arguments for and against interest rate hike fly thick and fast, there is a consensus emerging that although it is a step in the right direction, it only addresses the demand-side pressures. Amidst speculation that the Reserve Bank is likely to continue with its policy of increasing rates in the near future, there is also the danger of increased input costs driving inflation further while stagnating growth at the same time.

Though the Reserve Bank may argue that its hands are tied at this juncture, it will have to pay heed to voices in the financial industry which are warning that yet another hike might also impact the asset quality underlying advances such as project loans. There is sense in focussing efforts on battling inflation over maintaining growth rate in the short run, but in order to keep inflation in check in the long run, it is important to engage with the supply-side pressures of low productivity and efficiency. In this context, interest rate hike, at best, is only a ritualistic response to a deeper endemic plaguing the economy.

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