The Case For India To Raise Interest Rates Now Or Fall Behind The Curve

&l;p&g;&l;img class=&q;dam-image bloomberg size-large wp-image-40157146&q; src=&q;×0.jpg?fit=scale&q; data-height=&q;640&q; data-width=&q;960&q;&g; Urjit Patel, governor of the Reserve Bank of India (RBI), Photographer: Dhiraj Singh/Bloomberg

For the past few quarters, emerging markets have been experiencing a bull run. The low commodity prices (for commodity importers) and low interest rates have collectively acted as a rising tide for all boats. The easy money policy initiated by the Federal Reserve through quantitative easing flooded the global system with over $4 trillion. A lot of it ended up in emerging markets, where returns were higher &a;ndash; positively impacting all asset classes. Now that normalization is finally happening, rational expectations are doing the talking.

As yields on U.S. 10-year treasury breached the 3% threshold recently, there is a sudden uneasiness among emerging markets. It was so believed that the market was pricing in this event and American yield shock would not come suddenly. However, it did and apart from China, most emerging markets are apprehensive of the future. India is a case in point here. The Asian giant has been seeing its 10-year yields going up substantially since the second&a;nbsp;half of 2017. Despite having a stable macro-economic environment and stable interest rates, the uncertainty persists. The market is pricing India&a;rsquo;s bonds with a much higher discount and it is already apparent that Indian interest rates are behind the curve.

It is now clear that all emerging markets are not the same and evolving asset pricing are a barometer here. While China&a;rsquo;s case is helped by the recent cut in Reserve Requirement Ratio (RRR), no such epiphany occurred for the Indians. It is understood that China has now distinguished itself from other EMs since it has emerged as a refuge for global capital, now in a retreat mode. Even though the Chinese money market instruments were shored up by the 100 bps worth of domestic capital liberated from the RRR, the value gains in Chinese 10 year treasuries narrate a different story. Currently yielding in the range of 3.5 -3.6% range (with domestic interest rates at 4.35%), Chinese treasuries are in a league of their own.

However, when one looks at India, the other promised land in Asia, the chutzpah doesn&a;rsquo;t last. Indian 10 year treasuries are currently yielding around 7.8% with domestic hurdle rate (Repo) at 6%. While the higher discount for Indian debt vis-a-vis China is normal, given the latter&a;rsquo;s higher sovereign rating and economy size &a;ndash; what&a;rsquo;s not normal is the widening gap between India&a;rsquo;s short and long term yield, which is almost 200 bps. Also, when considering a 10-year bond on a zero coupon yield curve (ZCYC), it is worth noting that the market continues to price rate hikes in its assessment of Indian bonds. Between November 1, 2017 and April 26, 2018, the yield has increased by 77 bps.

Hypothetically assuming that a zero coupon 10-year bond is held for one year, 9-year forward rate calculations reveal that the market is already anticipating an 81 bps higher discount in the said period. This is equivalent to over three rate hikes in India. It is understood that in order to keep the yield curve from inverting, a certain differential between Repo and long term yields is necessary. Worryingly, the current situation augurs a possibility of sudden rate hikes in succession and not a gradual increase &a;ndash; eventually leading to volatility. The India situation appears very different to peers such as Russia and China, where the interest rates are more or less in tandem with yields. Smaller comparable difference in short and long term yields in those countries is a concern as well as it means that Indian long term debt is deemed riskier than ever.


The above-mentioned concerns are firmly attached to the following two considerations. First, as mentioned, the rising U.S. yields are a reality and the yield differential between Indian and U.S. 10-year is declining. The market is becoming uncomfortable with the status quo and this is evident in the bond pricings. Secondly, the market is anticipating more issuances from the Indian Government, which will be in turn missing its fiscal responsibility mandates, yet again in 2018-19. The bonds issued primarily for deficit financing and the bank recapitalizations, under the &q;Indradhanush Scheme&q; may lead to a demand-supply mismatch and hence low bond prices.

Since, anything to do with interest rates is a political matter in India, the Repo remains almost fixed at 6% since August 2017. This is primarily because the low interest rates are seen as conducive in driving demand in an economy that is suffering from the so called &a;ldquo;Twin Balance Sheet&a;rdquo; problem. India&a;rsquo;s Monetary Policy Committee (MPC) notes in its April minutes of meeting that even though the inflation concern is somewhat real, they want to wait and watch as the economy is in a recovery mode. Indeed, the economy has come a long way since the second&a;nbsp;half of 2014, when high inflation attracted high interest rates so much so that the yield curve became inverted. The build up towards a rate hike is however real and the MPC is hinting.

The situation is uncomfortably leading to a front loading of interest rates and the MPC may have to oblige with a tightening cycle sooner than later. It&a;rsquo;s almost like the market is demanding and anticipating a move. It would have surely helped if the MPC raised policy rates earlier, sensing the market reactions and potential threats from American yields. Contemplation is however a luxury India doesn&a;rsquo;t have at the moment. Rising rates is almost a done deal now. The move will be nonetheless detrimental to investor confidence and lead to volatility at a wrong time. A hard landing for India as taper tantrums are appearing more realistic than ever.

&l;img class=&q;size-full wp-image-9&q; src=&q;; alt=&q;&q; data-height=&q;306&q; data-width=&q;646&q;&g; Numbers, based on a zero-coupon yield curve


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