The outlook for interest rates for the next year is shaping up to be a slugfest between the forces of macro-economic growth and the impact of the demonetisation of high-value notes. On the economic front, there was good news to be expected. After two failed monsoons, we had a normal rainy season. Agriculture output and consumption was expected to rise in the coming quarters. On a broader level, consumers were spending again, as low inflation since 2014 allowed real incomes to rise. Even government spending was looking up, thanks to infrastructure spending in sectors such as roads, railways and defence. All this pointed to the end of the rate-cut cycle as stronger growth would eventually reduce the need for monetary policy accommodation. We should also note that the global outlook for interest rates points to higher rates, with the US Federal Reserve poised to resume hiking rates.
Demonetisation is likely to have a significant impact on the outlook for rates through three channels. First, it is likely to change the outlook for the fiscal deficit for the better. It is expected that a significant part of the 14 trillion rupees in high denomination notes would have been unaccounted money and, thus, would come into the tax net. To the extent that some of this cash would not be returned to the banking system, it would add to the Reserve Bank's profits (through a reduction in liabilities), and get remitted to the government as dividend.
The return of cash to the banking system also improves the liquidity of banks. This has resulted in banks reducing deposit and lending rates. To the extent that the cash drain from banks gets reduced in the medium term, we should expect rates to remain low for an extended period. Both the fiscal and banking impact of demonetisation points to lower interest rates. This is evident in yields in the bond and money market - they have fallen by 30 to 40 basis points since November 8. Lower yields imply higher prices, and bond markets have risen sharply during this time.
However, there is a risk involved as cash replacement is slow, leading to a drop in economic activity. India remains a predominantly cash economy with estimates that about 90 per cent of all transactions settled in cash. In the first 10 days, banks have taken in about Rs. 6.5 trillion, while only about Rs. 1.3 trillion of new notes have been distributed. If the cash crunch persists, normal economic transactions can be affected for several months, leading to a break in the growth we were expecting. As yet, the expectation is that, substantially, the cash needs of the economy will be met. Only those sectors which are heavily dependent on unaccounted cash - such as real estate - will be impaired for the long term.
As we look to the New Year, we would have to judge the relative impacts of the three forces - fiscal, banking and macro - on the direction for rates. In the near term, it is likely that rates and bond yields will remain low as the near term forces fiscal and banking are strongly suggesting lower rates. Four quarters from today, the impact of demonetisation should be well behind us, and we should look to a more normal trajectory for growth and inflation. On balance, we expect RBI to continue cutting rates and bond markets to continue to benefit from the outlook on fiscal deficit and macro-economic outlook.
This column is written by, R. SIVAKUMAR, Head - Fixed Income, Axis Asset Management Company
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