Inflation and interest rates seem to be on top of everyone's mind at the moment. Inflation figures recently touched a record high of 8.17 per cent. So is an interest rate hike imminent or is too much being read into market occurrences?
Personalfn decided to bring in the experts to do the talking on 'where interest rates are headed.' On our panel we have two distinguished persons. Mahesh Vyas, chief executive officer and managing director, Centre for Monitoring Indian Economy (CMIE is India's leading think-tank on the economy); and A K Sridhar, chief investment officer, UTI Mutual Fund.
Please share with us your views on the current state of the Indian economy and the kind of growth that can be expected in the near and medium terms.
Vyas: The revival of the monsoon is a great relief. This would ensure that fiscal 2004-05 would witness robust growth. We believe that the agricultural sector would not register a decline. It would grow, albeit at a slow pace of about one per cent. The various sops announced by the state governments and also the central government would ensure that farm incomes are protected and this could continue to fuel domestic demand. Real GDP is projected to grow by about six per cent.
Growth prospects in the medium term hinges upon growth in investments. Although there have been signs of an improvement in announcements in recent months, it is of critical importance to see these announcements being translated into setting of plant and machinery and providing fruitful employment.
There is no reason to believe that investments would not pick up. However, the announcements are limited to a select few industries. It is important that this spreads to many more.
Sridhar: Despite the concerns surrounding the impact of the monsoons on GDP, the key drivers of economic growth in the country remain intact. These include:
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A changing demographic profile with an increase in percentage of the population in the working age bracket coupled with the availability of cheap and skilled labour resources.
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Infrastructure development and growth in capital goods aided by improvement in global aggregate demand leading to growth in exports.
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Consumer spending and retail loan growth.
A proportion of the GDP growth we saw in FY04 was as a result of an agricultural rebound. However, while the sector grew at 9.1% (real terms), the contribution of agriculture to total GDP has reduced significantly to 22 per cent.
There has been a structural shift in the composition of GDP in India with the share of services increasing to 51 per cent of the real GDP in 2004.
While the impact of the monsoons on the kharif crop would result in agricultural growth remaining muted in FY05, the strength of the services sector as well as the industrial sector would compensate for this decline to some extent.
Contrary to initial expectations of agriculture growing at the trend rate of 3 per cent, we now expect agricultural growth to remain flat. Therefore we expect GDP growth in FY05 to be in the range of 5.5 per cent-6 per cent as compared to 8.2 per cent seen in FY04.
Over the longer-term horizon in order to maintain a trend GDP growth rate of 7 per cent-8 per cent, certain structural changes need to be further brought about in the economy. These include:
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Reduction in the levels of revenue and fiscal deficits and hence the levels of internal debt to GDP.
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Higher levels of saving led by a reduction in the levels of public sector dissavings.
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Increase share of capital expenditure in the total revenue expenditure of the Government.
How do you see the current rise in oil prices and the anticipated slowdown in growth of food grain output impacting inflation?
Firstly, let us not be misled by inflation as measured by the Wholesale Price Index. The WPI does not reflect anybody's consumption basket. It does not even reflect price changes in the wholesale markets as its name suggest. Thus, the near-8 per cent inflation suggested by the WPI is of no consequence.
I believe that inflation is benign at about 3-4 per cent as measured by the consumer price index. The rise in petroleum prices would provide some fuel for the rate perking up a bit. But, I do not see inflation being a major problem in the coming months of the year.
Even at about 4 to 4.5 per cent, inflation could be termed as quite benign. Inflationary forces are contained first by the revival of the monsoon and secondly by the government's intention to reduce customs duties to check prices. The policy move is particularly commendable.
Sridhar: The main contributors to the high levels of inflation seen in the recent past have been:
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Rise in fuel prices
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Rise in the commodity prices resulting in the rise in the manufactured WPI.
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Revision of the minerals index to reflect rise in the iron ore prices.
The rise in the fuel prices contributed to significant portion of the rise in the levels of the WPI inflation in the week ended August 7, 2004 which touched 7.96 per cent Y-o-Y. Going forward, it is expected that with the government taking steps to reign in fuel prices through a variety of fiscal measures, the inflation could have peaked for now. The cuts in import and customs duties announced by the government this week would probably ensure that the state oil companies remain on hold.
Moreover in September 2004, the high base effect of the last year is also likely to temper the Y-o-Y rise in the WPI provided ofcourse there no further rise in the fuel prices.
Primary market inflation, especially food inflation has been a cause for concern, with rising prices of fruits and vegetables contributing significantly to rising levels of inflation. However, food inflation could moderate, in line with the improvement in monsoon rainfall in early August.
We however expect full year average inflation to be in the range of 6-6.5 per cent as compared to 5.40 per cent in FY04
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Do you see the Reserve Bank of India responding to higher inflation in terms of raising interest rates? Also, how much of a pressure do you see rising interest rates in the developed economies exerting on India. Please share with us your expectations of how high interest rates are likely to go.
Vyas: The RBI has been making comments regarding the need to contain inflation. But, it would not be fair (or even possible) to pre-judge the bank. But, I hope the bank sees the need to focus on the CPI rather than the WPI.
Given that inflation is not really high there should be no pressure on interest rates. There is enough and more liquidity yet in the system. So, I do not see any pressure on interest rates in the months to come. Effective interest rates are likely to rise in sectors in which risk may rise. This could happen in housing loans and consumption expenditure loans. But, I see no tightening of liquidity anywhere on the horizon yet.
Sridhar: Indications are that there might be more fiscal measures by the government if global oil prices head higher, but the government and the central bank will remain "measured" in their response to higher inflation, avoiding any knee-jerk reaction. Moreover concerns on the monsoons impacting GDP growth would deter the RBI from hiking rates immediately, especially at a juncture when non food credit growth has just started showing signs of a pick up.
The yield on the 10-year government bond surged to 6.70 per cent recently, but fiscal measures and receding threat of an immediate rate hike by the RBI have brought it down to 6 per cent.
While the rise in the levels of inflation has been predominantly on account of cost push pressure rather than demand pull pressures, any further spurt in the levels of inflation would result in the Central Bank resorting to monetary measures to reduce the levels of liquidity in the system and thereby stemming inflationary pressure.
One possible monetary measure by the RBI to soak up has been increasing the levels of borrowing under the Market Stabilisation Scheme. The RBI had budgeted raising Rs 60,000 crore (Rs 600 billion) via the MSS which has now been raised to Rs 80,000 crore (Rs 800 billion).
In addition to inflation the other cause for worry is the fiscal deficit which is likely to be higher than initially estimated. Rising rates globally is also likely to exert some pressure on the RBI to follow suit especially with the Federal Reserve raising interest rates twice in succession. However with the recovery in the US economy now appearing to be far more shaky than was earlier perceived, the pace of rate hikes by the Federal Reserve in the US is likely to moderate than was earlier expected.
Do you see lending rates for the purposes of purchasing an automobile or a home for example rising in future?
Vyas: I see loans for consumer durables and housing getting slightly costlier in the coming months as I see the risk in lending to these sectors perceived to be rising.
Sridhar: The possibility of a rise in the lending rates for retail loan products is high given the rise in the yields on the government bonds. With a decline in the level of treasury profits for most banks, we could possible see some hike in the lending rates going forward as banks strive to maintain their margins. However, liquidity in the system continues to be high and any change in the prime lending rate would be have to wait for a decline in the levels of liquidity.
In your opinion, how significant an impact will higher inflation and consequently higher interest rates have on investment and consumption activity in the economy.
Vyas: Happily, there is no inflation; there is no high interest rates scenario on the horizon. So, there is no impact to comment upon.
Sridhar: As far as retail consumption growth is concerned, a mild rise in the levels of home loan rates or other retail loan rates would not have a significant impact on the levels of growth.
This is primarily due to the fact that with changing demographic profiles, there has been a marked rise in the levels of personal disposable income in the hands of consumers and as a result the EMI as a percentage of monthly income has significantly reduced.
Moreover with the low levels of penetration of mortgages in India as compared to other countries of the world, the growth in the level of home loans would remain intact. The only shift could be in terms of more consumers opting for fixed rate loans instead of floating rate loans.
Bank credit trends are buoyant, with non-food credit growth in excess of 20 per cent Y-o-Y. The increase is mainly attributed to continued buoyancy in retail lending and a shift from ECB borrowing to domestic sources. With increasing levels of capacity utilisation, the recovery in the capex cycle is imminent, though may get delayed due to economic and political uncertainty.
If you as an individual were given 100 units of money to invest in current times, how would you allocate amongst various asset classes.
Vyas: The answer to this question would be sensible only if you know my age, my family responsibilities, etc. Without this kind of personal information, my answer could get mis-interpreted. With this very important caveat you may know that I would put all the 100 units in equity if I were to invest the 100 units today.
Sridhar: For a person of 40 years (with a reasonable current income to run the day-to-day affairs) Rs 100 could be allocated as follows -- Rs 40 in equity, Rs 20 in short-term debt and Rs 40 in long-term debt/small savings instruments.
