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Interest Rates.. on the rise

On March 15, 2011 in a paper entitled “Growth – moderation to come” I argued that domestic liquidity remains scarce, as the rise in credit has been higher than that in new deposits and the Reserve Bank of India was not done yet with monetary tightening. Two weeks later the RBI hiked interest rates by 50 basis points. More recently, the State Bank followed with a rise in lending and deposit rates by 75 basis points. Its benchmark prime rate now stands at 14% and the base rate, below which it will not lend, at 9.25%. This will affect both consumption and new investment.

The Index of Industrial Production has been on a declining trend for several months and that for capital goods – an indicator of new investment – actually fell by 18.4% in February 2011. Whilst automotive sales have managed to cling on, it is unlikely that this buoyancy would be sustained in the coming months. Consumers will come under pressure with higher commitments and rising EMIs on home and personal loans. Purchase decisions for non essential products priced above Rs 20,000 may be deferred due to uncertainties about further rises. Economic growth is bound to tip over.

The rise in funding costs comes at a time when manufacturing segments of industry are already under strain with rising costs of oil, commodities and other inputs. Infrastructure companies involved in concession agreements complain that the viability of projects would need to be reviewed. Marginally viable ones such as those for roads and bridges may be delayed due to problems with financial closure. The hike in interest rates will impinge on the property markets as borrowing costs discourage investors and undermine margins for developers. I believe economic growth in 2011-12 may fall to 7.5 % or thereabouts, compared with earlier RBI estimates of 8.6%.

The RBI’s monetary stance which seeks to manage the growth-inflation trade-off, appears to have the support of the finance ministry. It is likely therefore that should inflation remain persistent, another bout of rate and liquidity hardening would transpire in the months ahead. This cannot be construed as good news for anyone and specifically CFOs burdened with large debts on their balance sheets. As profitability begins to decline and investors pull out, the rupee may come under some pressure in the forex markets. The challenge for industry would therefore shift from managing growth to controlling costs. The risk has now, almost certainly, switched to the downside.


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