From THE HINDU group of publications
Sunday, November 04, 2001


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RBI has to push for variable rates

Suresh Krishnamurthy

THE Reserve Bank of India has lowered the interest cap applicable to non-banking finance companies from 14 per cent to 12.5 per cent. The cap of 12.5 per cent has now been made applicable to Nidhis as well.

With this, the lowering of interest rates on all fixed income investment options is complete. Against the economic situation and the Centre's finances, the interest rate risk faced by investors in fixed income investment options has now scaled a new high.

Interest rates can move up if the economic activity revives. That would enhance the demand for credit and, thereby, create pressure on the liquidity in the system.

With the cash reserve ratio reduced to 5.5 per cent, the RBI's flexibility to combat the pressure on liquidity is also relatively low. As such, the system is vulnerable to interest rate shocks.

The nightmarish situation for investors would be an increase in interest rates along with a rise in inflation. This will mean incomes are linked to lower interest rates when expenses would have increased.

The situation is compounded because investors do not have any mechanism for hedging the interest rate risks. The RBI said in the Credit Policy that the preference of depositors and the traditional practice of banks have tended to favour fixed rate products.

While the RBI may be right about banks, the statement about the preference of depositors does not appear fully representative. For more than four years now, depositors have had no choice. It has been a borrower's market.

Banks and other institutions have been interested in coming out with floating rate products only when interest rates are at their peak. Naturally, depositors will not flock to invest in such instruments then.

Important, after the cycle of declining interest rates started, financial institutions have even stopped offering put options to investors.

Now, when interest rates are low and when quality investment options are scarce, none of the banks is likely to offer floating rate products or products with put options.

Investors seeking quality investment options have no choice but to continue investing in fixed rate products and remain exposed to the interest rate risk.

The only exception for investors could be the small savings products. The committee set up to look at revamping the administrated rate system has suggested that the interest rates on these products be linked to a suitable government security. Since this may be implemented when the interest rates are at a low level, investors would have a measure of protection against interest rate risk.

However, this may not be enough. The linking of interest rates would ensure that investors have variable rate products on only government borrowing schemes. Non-government investment options will continue to be on a fixed rate basis.

It is in this backdrop that the RBI must push Banks and Financial Institutions to offer variable rate products or products with put options. The products can be appropriately priced to compensate the issuing institution.

If investors continue to favour fixed rate products, then because of the lower interest rate on variable rate products, then it would mean that they are willing to take the interest rate risk. Until such time, it should not be assumed that investors do not prefer variable rate products.

For now, investors need to invest at least a portion of their money in mutual fund income funds. While this will not eliminate interest rate risk, it will at least ensure that fund inflows will allow them to benefit from any rise in interest rates.

Related links:
NBFC deposit rates cap cut to 12.5 pc

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