When will the party end?

It's six days into the New Year, Champagne corks have long stopped popping and celebrations everywhere have come to an end. Did I say everywhere? My apologies. I should have said everywhere except the debt market, where theparty shows no signs of flagging.

How long will the good times last? We heard that question last year as well, though sporadically. But now with yields on 10 year government paper collapsing to 6% " comparable in real terms to yields on 10-year US government securities " that's a question we're soon going to find on everyone's lips. And with increasing urgency.

Bankers, in particular, would give their eyeteeth to know. At the moment they're celebrating a Rs.30,000 crore windfall. Sure, each passing day seems to bring further confirmation that the good times are here to stay, but they know better than most, how fickle, markets can be, how quickly gains can be reversed.

Call it the great interest rate debate. Or more correctly, the great Indian rope trick; it is just as inexplicable. Ten out of ten commentators, including this one, have got it wrong. Not just once or twice, but again and again. Asked whether interest rates would continue to soften, all of us have, at some time or other, risked our reputation by hazarding the guess that rates have finally bottomed out. Only to watch incredulously as rates promptly took yet another tumble.

Six months ago when interest rates on ten-year govemment paper fell to 6.91%, this columnist had talked of how the market had acquired all the signs of an impending debt bubble. Of how the behaviour of interest rates was out of sync with macroeconomic fundamentals. How it was only a matter of time before banks realised it was suicidal, to keep taking deposits at 8% plus when these were going to be invested in gilts yielding much less. How the fall in rates was overwhelmingly liquidity driven, how corporate demand was bound to pick up and interest rates rise as a consequence. How the more than doubling of fiscal deficit " from Rs.60,243 crore in 1995-96 to Rs.135,524 crore in 2002-2003 according to budget estimates " would see government's borrowing grow astronomically and put pressure on interest rates.

Weighty, reasons every one. Except that markets didn't seem to care a fig for logic. Or for columnists' reputations, for that matter. Interest rates fell by another 100 basis points in the intervening period, leaving most of us scratching our heads for answers.

So where do we go from here? Is 5.98% " the cut off yield at last Thursday's auction of government securities " really the price of 10 year money? Economic training tells us it is not. So does past experience. But does any of this matter when the market seems to have taken leave of itssenses?

Let me elaborate.The problem is not with low interest rates per se. But rather with the implications of low rates for asset valuation in a scenario where interest rates are driven by irrational expectations rather than by macroeconomic fundamentals. As more and more players, convinced that prices are a one-way street bid up gilt prices/push down yields (yields are inversely related to prices), expectations tend to become self-fulfilling. In the process interest rates fall lower than warranted by economic fundamentals.

Ordinarily, this is when central banks should intervene. But the RBI is caught in a bind. It would like to keep interest rates low in order to spur investment and growth. But when low interest rates are essentially liquidity-driven (as they are at present) there is always the danger that somewhere down the line some of this excess liquidity could feed into prices. Remember, oil prices are already up and so are prices of edible oils. The wholesale price index has been inching up steadily and is now in the region of 3.5% as against about 2.5% last year. Should George Bush be foolish enough to launch a war on Iraq, prices will, in all likelihood, rise further.