If rates rise…

In all probability,the policy will signal an upward bias in interest rates. Last time round the RBI had hiked the Statutory Liquidity Ratio SLR from 24 per cent to 25 per cent. Statutory Liquidity Ratio or SLR is the money,as a percentage of fixed deposits,that banks need to invest in government securities. If this limit is hiked,it means banks have less money to lend. Will SLR be hiked again? Unlikely. We have come down form 30 per cent to 25 per cent over the past few years. The reduction from 25 per cent to 24 per cent was done last year in the aftermath of the October 2008 crisis. So that cut has been restored and a message has been conveyed. Dont expect SLR to change again.

Cash Reserve Ratio CRR is the amount of money,stated as a percentage of fixed deposits,which banks have to park with RBI. Banks earn no interest on their CRR deposits. A hike in CRR means that liquidity gets sucked out of the system,and banks have less money to lend. A hike in CRR also results in loss of income for banks,so banks are forced to charge significantly more from borrowers. There are expectations in some quarters that the RBI governor may raise CRR rates. But in doing so the RBI will risk credit growth,which has remained low since the crisis occurred. In my opinion,there is a 90 per cent probability that there will be no hike in CRR rate,and a 10 per cent probability that it will be hiked by 25 basis points bps.

Repo rate is the rate that RBI charges from banks when it lends money to them for the short term. If this rate is hiked,then again banks will have to pass on the higher rates to borrowers. The higher cost of borrowing could pose a threat to credit offtake. Hence,it is again unlikely that this rate will be raised.

Last comes the reverse repo rate. This is the rate that RBI pays to banks when they deposit money with it. The reverse repo rate is always lower than the repo rate. Under normal circumstances,call rates move within the band known as LAF corridor created by the repo and the reverse repo rate. The reverse repo rate is one instrument,which in my opinion,the RBI is likely to use this time.

There is ample of liquidity in the system,so much so that banks have been parking large quantities of money with the RBI. Today banks are being extremely choosy while lending. Since they cant find enough borrowers who satisfy their stringent criteria,they have been parking their extra funds with RBI.

High inflation behind hike expectations

The main reason why everybody expects rates to rise is high inflation. However,inflation is rising due to supply-side shortages of food products; it is not due to too much money floating in the system.

While RBI would want growth to continue,it must at the same time signal that interest rates are headed up. By hiking the reverse repo rate,it will achieve both,even though the price it will have to pay is a higher interest rate to banks.

Banks,on their part,will then have the option either to lend money to a business or to park it with RBI. But they will not have to charge higher interest rates from all borrowers. At the same time,they will be free to charge higher rates from risky borrowers based on their credit analysis.

If interest rates were raised,a huge amount of money from abroad would flow into our country. Foreign fund inflows will anyway be high,but a high interest rate will exacerbate the situation. This in turn will create upward pressure on the rupee,which will not augur well for exporters. Further,excessive inflows will force RBI to resort to open market operations OMO,which carries its own costs. Why would RBI bring these troubles upon itself by hiking rates precipitously?

Right now,we need more food supplies,not higher interest rates. But since that cannot happen overnight,hiking the reverse repo rate appears to be the least damaging option.

What should you do?

In a rising interest-rate scenario,you must exit long-term bond funds and invest in short-term funds. In such a scenario,shorter the term for which you lend your money,the better. If you lock in your money today at a low rate of interest for a long period of time,you will lose out on the opportunity to reinvest it a few months later at a higher rate. Hence,go for low average maturity schemes when rates are rising.

Go for liquid schemes or debt schemes with extremely low average maturity. Read the fund fact sheet to find out what the average maturity of your fund is. Liquid funds have low average maturity,but they pay higher dividend distribution tax compared to debt funds. These funds were earlier known as Liquid Plus Funds,but Sebi has now banned the use of the words Liquid Plus.

Floating-rate funds are another option you may consider. These funds invest in debt paper whose coupon rate rate of interest on the principal changes every few days. So if you expect interest rates to rise,investing in floating-rate bond schemes is a good strategy. Again,dividends from floating-rate schemes are taxed at higher rates than dividends from debt funds with extremely low average maturity.

Some asset management companies offer gilt funds that have both short-term and long-term options. Investing in short-term plans of gilt funds is by far the best strategy. Their low average maturity will nullify the risk arising from rising interest rates. And since these funds invest only in government securities,they carry no credit risk either.

The author is a financial trainer and is proprietor of Nagpur-based Money Bee Institute. Email: ashutoshmoneybee.info