Why Interest Rate Cuts Aren't Always Good...

Jun 15, 2016

In this issue:
» Services, the Pied Piper for Foreign Investments
» RBI's new scheme to fight against rising NPAs
» ...and more!
Radhika Pandit, Managing Editor of ValuePro

When the Indian Meteorological Department (IMD) predicted a robust rainfall this season, optimism spread far and wide.

Hopes increased for a revival in rural demand. For healthy crop production would ensure food prices remain in check. This in turn would keep inflation from rearing its ugly head...thus paving the way for the RBI to announce more interest rate cuts.

And once rates are cut, lending would take off and so would capex spending. This, as the theory goes, would revive overall economic growth.

That's the hypothetic big picture being painted. In this picture, growth appears to hinge on two factors - good rainfall and interest rate cuts.

The RBI, though, is in no mood to relent so easily. And rightly so. First of all, a prediction of good rainfall is simply not enough. It has to actually happen.

Where are we on that front, then, given we're already well into the first monsoon month? The Economic Times pointed out that in mid-June, there is already a 22% rainfall deficit. This has delayed crop planting and has fuelled a rise in the price of food, particularly vegetables.

So Rajan has to be lauded for taking a cautious stance and maintaining the status quo on rates. A shaky start to monsoons does not necessarily mean rainfall will not pick up in the coming weeks. It's just that Rajan would rather wait to see how the season pans out and the impact it will have on inflation.

The people, the government, and the stock markets may not be happy about the RBI's decision on interest rates. That's because they fail to understand one crucial point.

Interest rate decisions are not just about favouring lenders and borrowers. They are also about protecting savers. The thing is - you can't have a situation where the lending rates are lowered but the deposit rates are high. If lending rates fall, deposit rates have to follow.

Vivek Kaul, editor of Vivek Kaul's Diary, recently wrote about how interest rates work. Here's Vivek:

  • Raghuram Rajan, the governor of the Reserve Bank of India (RBI), explained this beautifully in a recent interview to NDTV. At a talk somewhere, a gentleman got up and told the governor that he should bring the interest rates down to 4%.

    Rajan asked this gentleman, if he were to bring the interest rate down to 4% from the current 5.5%, would he still deposit his money at the bank? The gentleman said no. So he was not willing to deposit his money at a low interest rate but wanted banks to lower their lending rates.

    To this Rajan said, 'Say a bank pays 6% on deposits and lends at 4%; who is going to make up for the difference? The idea is that somebody is going to pick up the tab. We are used to somebody picking up the tab. Who is going to pick up this tab?'

You simply cannot have it both ways. Here's Rajan and Vivek again:

  • 'One of the most difficult things in economics to understand is general equilibrium. You do one thing, it has other effects as well. If the interest rate on lending is cut, where is the money going to come for savings? Rajan asked.

    This is something that people who keep demanding lower interest rates at the drop of a hat don't seem to understand. There are two sides to bank interest rates: the interest rate banks charge on their loans and the interest rate they pay on their deposits. And if interest rates on deposits can't fall beyond a point, then the interest rate on loans can't fall as well.

We agree. Indeed, Vivek he has more such insights up his sleeve. And we can't wait to reveal them to you. Trust me, you want to watch this space...

Do you agree that RBI's interest rate policy is not all about favouring lenders? Let us know your comments or share your views in the Equitymaster Club.

02:46 Chart of the day

Amidst global slowdown, India's robust economic growth has been attracting a lot of foreign investments. Foreign Direct Investments (FDI) in the country hit an all-time high of US$ 41 billion in FY16. A closer look at the numbers indicates that services continued to attract the largest investments, riding on the wave of e-commerce and start-ups. But the employment generating manufacturing segment has remained a laggard. Large manufacturing sectors such as construction development, automobiles and drugs and pharmaceuticals recorded a decline in FDI flows in FY16.

This is worrisome as India is already battling chronic unemployment. India's unemployment rate grew from 6.8 per cent in 2001 to 9.6 per cent in 2011, according to Census 2011 data. If numbers from Labour Bureau's quarterly employment are to be believed, then the job creation dipped to its six-year low in 2015. Most of the job creation that has taken place during the year has been on account of the IT/BPO sector. The unemployment problem in India has been compounded by poor industrial growth, low agricultural production due to two consecutive drought years and streamlining of costs by manufacturing firms. Moreover, increased mechanisation of operations in labour intensive industries has led to a fall in jobs.

But if India wants to benefit from the demographic advantage, it needs to create the enabling environment for manufacturing business. Although the government has been making concerted efforts to attract investments in manufacturing through its 'Make in India' campaign, the same is yet to yield results.

Services, the Pied Piper for Foreign Investments (FY16)


The Reserve Bank of India added another weapon in the bank's arsenal in its fight against spiralling NPAs. The new Scheme for Sustainable Structuring for Stressed Assets (S4A) is an improvement over the Strategic Debt Restructuring (SDR) scheme that was launched earlier. It particularly overcomes the drawback wherein banks were finding it difficult to sell off assets after taking management control of a company and converting debt into equity.

Under the new norms, a bank will determine the sustainable portion of the debt that can be serviced by the borrower and then convert the remaining debt into equity or equity-like securities. However, the scheme poses its own set of challenges. Foremost among them are the requirements for the project being commercially operational and the sustainable portion of the debt being not less than half of a borrower's total loan. This will not be helpful in case of power projects awaiting necessary clearances or cash strapped infrastructure companies. Even if the first two conditions are met, the absence of restructuring in the sustainable debt will impede companies already struggling with poor cash flows. Moreover, high provisioning requirement equal to 20% of overall debt is likely to curtail the bank's profitability.

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Indian stock markets after opening the day in the green managed to remain buoyant. The BSE Sensex was trading higher by 124 points (0.47%) at the time of writing. Capital goods and power stocks were leading the gainers, while consumer durable stocks were at the receiving end.

04:55 Today's investment mantra

"You don't need to be a rocket scientist. Investing is not a game where the guy with the 160 IQ beats the guy with 130 IQ."- Warren Buffett

This edition of The 5 Minute WrapUp is authored by Radhika Pandit (Research Analyst) and Madhu Gupta (Research Analyst).

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2 Responses to "Why Interest Rate Cuts Aren't Always Good..."


Jun 15, 2016

The bone of contention between Mr. Swamy and RBI is the interest rates for MSME and not the interest rates in general. While not going into the details of that controversy, I believe that for the overall economic growth, as Mark Ford keeps pointing out, small businesses are key. If MSME are getting impacted and thereby the employment generation and the overall growth, then I tend to believe that the interest rates for MSME needs to be relaxed and funds need to be available at a cheaper rate. The environment for small businesses should be encouraging but the current policies do not seem to be encouraging, isn't it? Also, on the other hand, by changing the definition of how banks treat NPAs and marking more and more loans as NPAs, we are probably sending out wrong signals and making it non-conducive. Some of these so called NPAs may not have been genuine defaulters. However, the last point is outside the topic of discussion and hence we can ignore it. Please let me know your thoughts on the issue of RBI not reducing interest rates for MSME.


muni ram garg

Jun 15, 2016

sir my personal view about market is when market is up no factor works & vice versa iam watching this position since 20 yrs

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