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Drought unlikely to prompt bank rate cut

Anirban Nag in Mumbai

Expectations in the government bond market that a worsening drought boosts chances of a near-term interest rate cut by the Reserve Bank of India may be overdone, a senior banker told Reuters.

Market talk of a rate cut surfaced last week amid the worst drought in more than a decade. The Indian economy is highly dependent on agriculture, which employs 70 per cent of its one billion population and is crucial to consumer demand.

But interest rate policy is unlikely to be changed until October despite the spectre of drought or a recent spike in weekly inflation driven partly due to rising food prices, the banker said.

"I see no pressure on interest rates or the need to respond to the drought conditions or the inflation," the banker, who spoke on condition of anonymity, said late on Tuesday.

Talk of a possible cut in the benchmark bank rate cut is supporting government bond prices close to multi-month highs and balancing pressure from Rs 70 billion of upcoming government supply due on August 2.

The banker said there was ample liquidity in the Indian financial markets -- as measured by overnight interest rates, government bond yields and corporate bond rates -- and current low rates were sustainable.

The benchmark 10-year bond yield edged down to 7.31 per cent in morning trade on Wednesday as dealers interpreted plans for a smaller-than-expected central bank auction due Friday as a sign authorities want liquidity to remain adequate.

Smaller central bank bond auctions help keep yields low and are likely to offset any lowering of expectations of a rate cut.

Ten-year yields were 7.325 per cent at Tuesday's close, barely changed from Monday but higher than Saturday's three-month low of 7.27 per cent.

"A logical case for easing seems more credible now than anytime since the April monetary policy when the central bank retained the option of cutting the bank rate by 50 basis points," ICICI Securities and Finance Company said in a weekly commentary on Tuesday.

The bank rate is currently at a three-decade low of 6.50 per cent and has not been reduced since October last year while the short-term repo rate was cut by 25 basis points to 5.75 per cent in the last week of June.

The banker said problems in the agricultural sector were unlikely to weaken the rupee, which is tightly managed by the central bank although it could cause some short-term volatility.

The rupee, convertible only on the current account, has gained 0.8 per cent from its historic low of 49.08 per dollar hit on May 16 due to increased trade inflows, remittances from expatriate Indians and due to dollar weakness.

The banker said although a continuation of the drought would hit the large Indian agricultural sector, which makes up around a quarter of gross domestic product, the government could use huge grain reserves to prevent any shortages or price spikes.

FOOD STOCKPILES

The government has in recent years brought grain from farmers through the Food Corporation of India, leading to an enormous stockpile currently at over 65 million tonnes.

Analysts expect the food subsidy bill to rise by Rs 15 to Rs 20 billion this year as the government grapples with drought conditions and tries to sell some of these stocks through the public distribution system which channels grains to the poor at subsidised rates.

Including the costs of storing and transporting foodgrains, the food subsidy is budgeted at Rs 212 billion for 2002-03, having risen four times in the past eight years.

Analysts said the government could also hike the minimum support price -- a rate which is usually higher than the prevailing market prices -- offered to farmers to compensate for the fall in output due to the drought.

India ranks second in the world in rice and wheat production, just behind China and is among the top rice exporters mainly due to the price advantage on account of subsidies rather than quality.

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