India has been witnessing a declining interest rate regime over the past few years and there has been increasing speculation on the future direction of interest rates.

In the past one year, interest rates have shown a consistently declining trend with the yields on Government Securities declining by about 100 basis points across the entire maturity spectrum. This trend has been amply reflected by CRISIL Gilt~X (principal return Gilt Index) which has gone up from 1083 points in January, 1999 to 1114 points in September,1999.

In its latest publication of CRISIL ALERT, CRISIL has stated that the downward trend in interest rates is unlikely to continue into the next millenium. Interest rates are expected to go up in the medium term due to a mismatch of supply and demand of funds in the system.

Demand for funds is expected to be higher than 1998-99 levels due to higher demand from both the Central Government as well as the Corporates. Central Government gross borrowings in fiscal 1999-2000 are expected to be higher than the targeted level of Rs.860 Billion (Bn) (net borrowing of Rs.560 Bn) by about Rs. 180 Bn on account of lower PSU divestment, lower tax revenues and expenditures on Kargill & elections. Incremental corporate demand for funds from banks is expected to be about Rs.700 Bn in 1999-2000 as against Rs.570 Bn in the previous year due to an expected increase in IIP growth from 3.8% in 1998-99 to 5% in 1999-2000. In fact, incremental advances to corporates by banks (including investments) between April to September 1999, are already higher by Rs.42 Bn in comparison to the corresponding period last year. Additionally Government redemptions from FY 2000-2001 to FY 2004-2005 are estimated to be between Rs.275 – Rs. 310 Bn as against Rs 148 Bn in 1998-99, creating additional demand pressure in the medium term.

Supply of funds on the other hand is expected to be lower than targeted levels on account of slowdown in both, bank deposit growth as well as external inflows. The net inflow of funds through FII, FDI and ECB is expected to remain at last year's level of Rs.270 Bn. despite an increase in FII inflows due to lower mobilisations through the ECB route. The aggregate deposit expansion in the banking system in 1999-2000 is expected to be only about Rs.1000 Bn as against a deposit growth of 1100 Bn last year. Moreover this slowdown in bank deposit growth is expected to continue due to increased investment in real assets (gold and housing), lower mobilisation from external deposits because of the absence of RIB which contributed Rs.179.5 Bn last year, increased fund mobilisation by Mutual Funds (they have already shown a net mobilisation of about Rs.50 Bn this year as against a net outflow of Rs.7.9 Bn last year), increased retail mobilisation by DFIs like ICICI and IDBI (they are expected to mobilise about Rs.80 Bn this year) and increased investment in capital markets by households due to strong secondary market sentiments.

Thus, according to CRISIL, even assuming a CRR cut of 1% before the end of the year there would remain a large shortfall of funds in the system. Therefore interest rates are expected to harden before the end of the year. This hardening will be more pronounced in case of higher risk corporates due to the risk averse nature of various lending institutions like banks, mutual funds, pension funds and small savings.

CRISIL has stated that the expected increase in interest rates should be a matter of serious concern to banks and mutual funds, as government and corporate securities constitute a large portion of their portfolio. In its assessment, a 1% increase in interest rates could lead to as much as a 4% decline in the outstanding portfolio value of banks and mutual funds. Considering that banks have an outstanding portfolio of government and corporate securities of about Rs. 3500 Bn, this implies that a one percent increase in interest rates could lead to a decline in outstanding portfolio value by as much as Rs.140 Bn.

CRISIL has stated that it is therefore of primary importance that institutions increasingly pay attention to managing their interest rate risk.