VR Logo

Growth Gets Sidelined

A pattern of low/negative real interest rates occurred in India between 2004-06 and helped fuel the boom of the period

When it comes to signals, interest rates are the most overworked of financial indicators. Rising inflation is marked by rising interest rates. Money supply is inversely linked to interest rates — more money in circulation usually leads to lower rates, and vice versa. Equity values are also inversely tied to rates. If rates rise, equity prices fall.  

A full business cycle of boom-bust-boom sees a characteristic sequence of interest rates and inflation. At peaks, interest rates run higher than inflation, making money expensive. At bottoms, inflation and interest rates tend to be low and often, real interest rates turn negative. That is, inflation runs higher than prevailing interest rates.  

Negative interest rates can help kickstart economic recovery. When money is available effectively for free, funding can be raised easily to boost capacity expansions and to increase consumption demand.  

This pattern of low/negative real interest rates occurred in India between 2004-2006 and helped fuel the boom of that period. From late 2006 onwards, interest rates were positive, and by 2008, real rates were high. Judging exact levels is difficult, both because of poor data-gathering mechanisms as well as a plethora of interest rates.  

Inflation is now showing a positive trend. On point-to-point basis, the wholesale price index (WPI) has turned positive, while consumer price indices are running very high, at about 12 per cent or more.  

Now, central bank policy and government policy consists of tinkering with money supply and interest rates to balance contradictory needs to encourage growth (by lowering rates and easing money supply) and to control inflation. Most commercial rates are market-driven, as are yields on auctioned government securities and T-Bills. But the Reserve Bank of India (RBI) can tighten or ease money supply through various measures.  

The RBI also sets policy rates, like the repo and reverse-repo. These are the rates at which the RBI lends to, or borrows from banks. Repo and reverse repo rates and G-Sec yields are zero-risk, unlike commercial loans. Hence, commercial loans are always issued at rates exceeding G-Sec yields.  

Over the past year, the RBI was clearly trying to ease rates. It slashed repo to 4.75 per cent (from 9 per cent) and the reverse repo to 3.25 per cent (from 6 per cent). It eased money supply, reducing the cash-reserve-ratio (CRR), to 5 per cent of deposits, from 9 per cent. It also lowered the Statutory Liquidity Ratio (SLR), to 24 per cent of all liabilities that a bank must meet within the next 30 days. 

The rate cuts and easing money supply may have helped mitigate the downturn. But the RBI's latest credit policy shows that it is now more concerned about curbing inflation and preventing real estate bubbles, than about fostering growth.  

It now projects inflation (WPI) will hit 6.5 per cent by March 2010, up from earlier targets of 5 per cent. It also hopes that GDP growth will cross 6 per cent in 2009-10. It has raised the SLR to 25 per cent while keeping policy rates and CRR unchanged. It has also hiked mandatory provisioning for real estate loans.  

Technically, the SLR hike will result in Rs 30,000 crore being made unavailable for commercial lending. In reality, it is more a policy indicator than a hike, since banks have an average SLR of about 27-28 per cent. But the Government of India  is also running a massive deficit, which is funded by borrowings through the issue of fresh paper. So, interest rates will at best, stay stable, or rise in the second-half of 2009-10.  

It's a moot point whether the RBI should have done this, however, consumer inflation has already hit levels where the political establishment is nervous. The immediate impact on banking and financials has been negative. Real estate stocks have been massacred. Both banking and realty are heavyweight sectors and the sell-offs have pulled the Nifty/Sensex down by almost 10 per cent.   

Implications for overall equity valuations remain negative. It is difficult to justify trailing price-to-earnings (P/E) ratios higher than 15-16 on the basis of the currently prevailing G-Sec and commercial rates. Since the Nifty is held at a P/E of 20, at the current levels of 4,700, further downsides cannot be ruled out.  

However, a trend of rising rates also makes debt unattractive. Hence, a long-term passive investor should probably continue to systematically average down. Slice exposure to realty stocks and buy heavily into index funds if the Nifty slides below 4,500.