Financial Times

Interest rates rise as Govt. struggles to fight inflation
Interest rates are on the rise following last week’s Central Bank rate hike as the government tries to dampen inflationary tendencies in the economy and prevent speculative bubbles developing, analysts said.

More rate hikes are expected following last week’s one, the second this year, with interest rates still hovering below the inflation rate. “The direction is clear – interest rates are moving up,” declared S. Jeyavarman, CEO of the NAMAL fund. “Also, market expectations are that interest rates will rise further because they are still far below the inflation rate.”

Commercial banks are expected to raise their own rates after the Central Bank raised benchmark rates by half a percentage point. The overnight repurchase rate was raised to 8.25 percent from 7.75 percent while the reverse repo rate was increased to 9.75 percent from 9.25 percent.

Higher interest rates could raise the cost of borrowings slightly for corporates but this is unavoidable given the government’s need to ensure price stability.
“If not, the cost of living increasing will have other implications for business,” said Jeyavarman. “Not only wages, but other costs such as raw materials could go up. To prevent high inflation affecting the economy, the Central Bank has got to balance interest rates and price levels.”

However, other analysts said they doubted the Central Bank would be able to curb galloping inflation with interest rate hikes, and warned this could dampen economic growth. Inflation increased to 12.4 percent in May 2005 its highest level since March 2002.

Brokers Asia Securities anticipates inflation to rise further in the short term amidst recent petroleum retail price hikes, higher bus fares and likely higher electricity and gas rates.

They said the benefits of a stronger rupee are yet to be passed on to consumers. However, the brokers said they remain unconvinced that the Central Bank's strategy of increasing interest rates to combat inflation will succeed in containing what they said appeared to be mostly cost-push inflation.

“Higher interest rates are usually more effective in moderating inflation that arises due to demand-pull factors, arising from excessive demand for credit in over-heating economies, with only a limited indirect impact on cost-push inflation, by way of a stronger currency limiting imported inflation.”

The Central Bank’s recent tightening of monetary policy may not have the desired impact on inflation and could possibly contribute to a further slowing down of the growth momentum.This was because there is little evidence of an over-heating of the economy with most indicators pointing to a slowing down of economic growth and the benefit of a stronger currency not being passed on to consumers by way of lower imported prices, the brokers said.But there are fears that the low cost of credit could prompt borrowing for speculative investments such as property creating a property bubble.

“Raising rates would make the cost of credit more expensive,” said Jeyavarman of NAMAL. “People would not borrow money for unwanted purposes. When interest rates are low and inflation high, there’s a tendency to borrow.”

The Central Bank is trying to contain the high money supply growth by raising rates to rein in inflation, probably in the hope that it would not be forced to raise interest rates too much.

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