Relation Between Bank rate and Govt Rate

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.