Interest rates in India are much lower than
they should be given the rate of consumer price inflation and the rate of
economic growth. The return on a 10-year government bond as of now is around
7.4%. A 10-year government bond is a bond sold by the Indian government to
finance its fiscal deficit or the difference between what it earns and what it
spends. Anyone investing in a bond basically looks at three things: the
expected rate of inflation, the expected rate of economic growth and some sort
of risk premium to compensate for the risk of investing in the bond. These
numbers are added to come up with the expected return on a bond.
The consumer price inflation in the month
of May 2013 stood at 9.31%. As per most forecasts the Indian economy is
expected to grow at anywhere between 5-6% during this financial year (i.e. the
period between April 1, 2013 and March 31, 2014). Lets assume that lending to
the Indian government is considered to be totally risk free and hence consider
a risk premium of 0%. Also to keep things simple, lets assume a consumer price
of inflation of 9% and an expected economic growth of 5.5% during the course of
the year. When we add these numbers we get 14.5%. This is the rough return that
a 10-year Indian government bond should give. But the return on it is around
7.4% or half of the projected 14.5%.
The reason for that is very simple. Indian
banks need to maintain a statutory liquidity ratio of 23% i.e. for every Rs 100
that a bank raises as a deposit; it needs to compulsorily invest Rs 23
in government bonds. Hence, banks (and in turn citizens) are forced to lend to
the government. Similarly, Life Insurance Corporation of India also invests a
lot of money in government bonds. So there is a huge amount of money that gets
invested in government bonds. This ensures that returns on government bonds are
low in comparison to what they would really have been if people and banks were
not forced to lend to the government. The return on government bonds acts as a
benchmark for interest rates on all other kind of loans. This is because
lending to the government is deemed to the safest, and hence the return on
other loans has to be greater than that, given the higher risk.
If the 10-year bond yield would have been
at 14.5%, then the interest rates on loans would have been greater than 17%
(14.5% + 285 basis points). But since the government forces people to lend to
it, the interest rates are lower. This act of the people being forced to lend
to the government is referred to as financial repression.
This means our savings will increasingly be
diverted to government interests, whether or not those interests really deliver
a good rate of return for society. While
this may happen in the Western societies as governments resort to financial
repression to repay the huge amounts of debt that they have accumulated, it is
already happening in India. Financial repression is a major reason behind the
Congress led United Progressive Alliance (UPA) government going in for a large
number of harebrained social programmes (the most recent being the right to
food security, which has been brought in through the ordinance route). They
know that money required for all these programmes can easily be borrowed
because 23% of all bank deposits need to be invested in government bonds issued
to finance the excess of government expenditure over revenue.
This is also why interest rates offered on
bank fixed deposits are close to the rate of consumer price inflation, leading
to a zero per cent real rate of return on investment. This is also makes people
buy gold and real estate and invest in Ponzi investment schemes, in search of a
higher rate of return.
Banks raise deposits at a certain rate of
interest and then give out loans at a higher rate of interest. So unless the
interest rate offered on deposits goes down, the rate of interest charged on
loans cannot come down.
Banks are not in a position to cut interest
rates on deposits as of now. Hence, it is not possible for them to cut interest
rates on loans. Any bank which cuts interest rates on loans will essentially
end up with lower profits. Also even if interest rates on loans are cut, it may
not lead to people borrowing and spending money.
Lets first consider car loans. Car sales
have fallen for the last eight months in comparison to the same period during
the year before. High interest rates are a reason offered time and again for
slowing car sales. But some simple maths tells us that can’t really be the
case.
Lets consider the case of an individual who
borrows Rs 5 lakh to buy a car at an interest rate of 12% repayable over a
period of 7 years. The equated monthly instalment for this works out to Rs
8826. Lets say the bank is able to cut the interest rate by 0.5% to 11.5%. In
this case the EMI works out to Rs 8693, or Rs 133 lower. Even if the bank cuts
interest rates by 1%, the EMI goes down by Rs 265 only. If we consider a lower
repayment period of 5 years, an interest rate cut of 0.5% leads to an EMI cut
of Rs 126. An interest rate cut of 1% leads to an EMI cut of Rs 251. The point
is that no one is going to go buy a car because the EMI has come down by a
couple of hundred rupees.
With the uncertainties prevalent today, a
consumer does not know what his job would be like after a year – whether or not
he will have an incremental income, or even a job. Of course when people are
not buying cars, it is unlikely they will buy homes, unless we are talking
about those who have to put their black money to use. A cut in interest rates
will bring down EMIs significantly on home loans. But even with lower EMIs
people are unlikely to buy homes. This is because the cost of homes especially
in cities has gone up big time making them totally unaffordable for most
people.
The broader point is that just asking banks
to cut interest rates doesn’t make any sense without trying to address the
other issues at play.
