The rupee is falling, oil price is rising and stock markets are searching for a bottom.
Every monetary policy meeting gives rise to a debate over whether the RBI should increase interest rates. This time, too, it is not different as the external environment, equity markets, credit markets and the general sentiment are down. The rupee is falling, oil price is rising and stock markets are searching for a bottom.
Over the past few weeks, the whole financial system in India has been going through a turmoil. The upheaval was triggered by defaults at Infrastructure Leasing and Financial Services Ltd (IL&FS), and other Non-Banking Financial Company (NBFC) and Housing Finance Companies (HFC). The Central government took prompt action by superseding the IL&FS board and is trying hard to bring in a Satyam-like resolution to the problem. For the time being, the fear and rumours have been nipped in the bud.
IL&FS was one of the largest Infrastructure lenders in the country and a default by it has disturbed the well-oiled Commercial Paper (CP) market. CP is a short-term financial instrument used by corporates to raise money from a few days to a year. Banks and mutual funds are main investors in CPs. The total outstanding CP issuance by all corporates as on September 15, 2018, is Rs 6,40,000 crore, out of which, more than 60 per cent is raised by NBFC and HFC. CP is a preferred mode of raising short-term money for companies as it offers lower interest rates when compared to banks interest rate for loans.
Post the IL&FS default on their repayment of CP, large investors have withdrawn from the CP market. They are scared of further defaults and losing their investment. This has led to liquidity drying up for NBFC and HFCs. Now, why is it important that the CP markets remain well oiled? After 11 PSU banks were put under Prompt Corrective Action (PCA) by the RBI, there were further restrictions on these banks on new lending. This opened up the opportunity for NBFC and HFC to capture this market and bridge the need by corporates. After all the raw material for NBFC and HFC is ‘money’ and when the flow of money dries up so does the finished goods and, in this case, lending slows down by NBFC and HFC. Hence, even if the IL&FS issue is sorted, it may take nearly a quarter for the investors to start lending again at the same pace as they were doing before the problem started. This will obviously slow down NBFCs growth and also credit flow into the economy.
Meanwhile, the Consumer Price Inflation (CPI) was at 3.69 per cent, which is well under the RBI’s targeted inflation rate of 4 per cent. It is remarkable that even after the increase in MSP and oil prices, the Consumer Price Inflation for March 2019 is expected to be around 4.70 per cent and for the full year average of 4.40 per cent to 4.50 per cent. This is within the stated range of inflation targeted by RBI. The CPI is expected to be low mainly due to low food inflation and MSP benefit being passed on to the farmer directly, thus as per the stated policy of keeping interest rates 2 per cent over the average CPI inflation has already been achieved.
While inflation is under control, the speed with which the Indian Rupee (INR) is falling against the dollar is a cause of concern. Countries like Turkey, Argentina and Indonesia have tried to address currency depreciation by hiking the interest rate and have failed miserably. Addressing the currency depreciation with interest rate hike is a very blunt tool. India’s currency woes need to be solved by taking more concrete steps toward containing the Current Account Deficit (CAD). But factors like crude prices are beyond the control of the India government. Though the steps taken by the government to reduce petrol and diesel prices by Rs 2.50 per litre are welcome, maybe it’s time to adopt new measures to curtail the overall fuel consumption through innovative means.
RBI has raised REPO rates twice this year from 6 per cent to 6.25 per cent in June and 6.50 per cent in August. By doing this RBI has moved along with the interest rate curve. The government securities market is extremely nervous and is already trading substantially higher to the long-term average spreads of 100 bps over Repo rate. The 10-year government security bond is being traded at 8.20 per cent which is a spread of 170 bps higher. This is an unusually high interest rate for a government to borrow from the market. The borrowing cost of the government is growing rapidly and high-interest rates can dent the future growth of the country. Even from real interest rate perspective, RBI is targeting a positive interest rate of 1.50 per cent to 2 per cent, whereas we are already in positive interest rate territory at 3.36 per cent as per the current bond rates pricing in the market.
In such a scenario it is time for the RBI to be bold and brave. The first steps taken by RBI towards resolving this situation was announcing Rs 36,000 crore of open market operations (ie, buying government bonds from open market). This basically helps in infusing much-needed liquidity into the debt markets. The money markets need assurances to soothe and calm the nerves of its investors so that liquidity can come back to these markets.
Government steps toward resolving IL&FS and RBI’s Open Market Operation announcement is in the correct direction. Raising interest rates after two consecutive rate hikes may not be an effective way to stop the rupee from depreciating further. Especially when the inflation is not showing any signs of running away. However, by keeping the interest rates steady and a neutral liquidity position with a bias towards easy liquidity when the markets require it, may help the markets to calm down its nerves, along with removing some of the PCA restrictions on PSU banks could keep the financial engine chugging.
(The author is the promoter-director of Sunidhi Securities & Finance Ltd)