Should interest rates be raised to 17%? - The 5 Minute WrapUp by Equitymaster

# Should interest rates be raised to 17%?

Jul 8, 2013

In this issue:
» Nothing to look forward to this earnings season?
» Another reason for delay in infra projects?
» Inflation maybe down, but veggie prices are soaring
» Is Eurozone out of the woods?
» and more....

 00:00
We came across a very interesting article in Firstpost recently. It talked of interest rate levels in India. In the daily's opinion, the interest rates in India should be around 17%. As far reached as it sounds, Firstpost has actually given the math to justify their assumption. Let us go through their calculations first to understand why they expect interest rates to be so high.

The current rate of return on the 10 year Government bonds, which is a proxy for risk free rates, is around 7.4%. Now as per the author of Firstpost this rate should be a sum of expected inflation rate, expected growth rate and risk premium. The last variable would be zero as it is assumed that the return on 10 year bonds is risk free. The consumer inflation in the country is in excess of 9%. At the same time the expected growth rate is in the region of 5% to 5.5%. This means that the rate on the 10 year bond should be around 14.5%.

If that is the risk free rate then the prevailing interest rate on loans would be higher. Currently the banks charge around 10.25% as interest on loans. This means there is a difference of 2.85% between the interest on loans and interest on 10 year bonds. By this logic the interest rate on loans should be over 17% (14.5%+2.85%).

We feel that the author's logic is correct but his calculations maybe wrong. This is because expected growth rate is not necessarily a component of interest rates of bonds. So it would make more sense to take 9% of inflation + 2.85% of premium over 10 year bonds + 2.5% of premium which is necessary to achieve a positive real rate of return. This means that the interest rates should still be around 15%.

This would make sense right? But then why is it that the Finance Minister is asking banks to cut their interest rates? That is because unless the interest rates are brought down by banks, credit growth in the country will stall. For an economy that is battling a slowdown, stalling credit growth would be the worst piece of news.

So why are the banks not cutting their interest rates despite the Finance Minister's pressure? The answer to that lies in the calculations given above. Given the high level of consumer inflation in the country and slower growth rate expectations, banks have to offer attractive interest rates to lure deposits. So the amount of money they have available to them to lend out will get squeezed if they cut rates on deposits. And if they bring down interest rates on loans, then their own margins will come under pressure.

As we can see clearly, the troubles are basically due to the high consumer inflation. That has been the result of the government's actions. It has been too busy spending money in populist programs to gather electoral votes rather than spending time in policy reforms and economic action. Its attitude on red tapism has not helped either. The number of projects stuck in the clearance routes are just growing by the day. The government needs to wake up and smell the coffee. Making the banks appear as the culprits for stalling economic growth is not the solution. It is high time it shouldered some of the blame for India's problems. But is it ready to that?

Do you think that the banks should cut down interest rates or raise them further? Please share your comments or post them on our Facebook page / Google+ page

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 01:30 Chart of the day
The Indian equity markets have been on a roller coaster ride since the beginning of this year. The foreign institutional investors (FIIs) have been blamed for a large part of this volatility. But it is interesting to note that the mutual funds have not been big fans of equity either. In fact they have been selling equities till May this year. At the same time, their investments in debt have been soaring., This may make one wonder if it is indeed time to follow the lead of the funds and move out of stocks as investments. But we feel that this would be a myopic and in fact a wrong way to look at stocks. Fund buying and selling is nothing but short term events. This leads to over exuberance as well as over pessimism in the markets. Such events should be treated as opportunities to buy the fundamentally strong stocks at cheaper valuations. Because eventually the short term blips will smoothen out and stock prices will reflect the underlying fundamentals

 Source: Financial Express

 02:00
With rains covering most of India, chances are that the view from your window is that of a rather gloomy weather. Well, it seems no different in the stock markets. The June quarterly results are upon us and even here, the corporate weather seems much the same. Historically, what has come to be termed as good growth in earnings is something in the range of 12%-15%. But will this be the case this time around? Save for a handful of companies, the others are unlikely to come anywhere close to this number. Simply because not only has GDP growth been lacklustre but the sharp depreciation in rupee has put further pressure on the cost structure. Of course, fall in commodity prices have provided some relief. But this will mostly be offset by the sharp fall in rupee we believe.

However, since markets think ahead, most of the gloom seems to be already reflecting in the current stock prices. And thus if we are looking to invest in stocks, we should be worried about earnings trend two to three years down the line and not what will happen in the latest quarter. Doing this would ensure that a fundamentally strong stock that gets unduly punished for putting up lacklustre performance over the next quarter or so doesn't escape our radar. Buying into such stocks provided the valuations turn attractive is one of the best market beating strategies out there.

 02:30
Infrastructure development is one of the top priorities for nations, and often a key indicator of their economic growth. The same theory holds true for India as well. Indian infrastructure sector is often plagued with delays. The slow progress by the government on infrastructure related projects is a hurdle for the industry, if not a barrier. Now, the infrastructure companies are facing a unique challenge. Apart from land acquisitions and red tape, companies are facing severe skilled manpower shortage. According to the study submitted to the ministry of statistics and programme implementation, 80% of the developers are unable to find skilled project managers to execute projects on the ground. Even though a large numbers of engineers graduate every year, there is a huge gap between their skills and the readiness of their usability in the industry. If a talent pool has to be built fast, places like innovation hubs, R&D labs are required. This can happen by government impetus, and a radical overhaul of the vocational education system.

 03:00
What would you hold responsible for the multi fold rise in your household food budget over the past year? The rain fury in the North? The drought in Maharashtra? The government? Or the rate cut reluctant central bank? According to an article in Firstpost, blame on either of these would be misplaced. For the real culprits are profiteering middlemen and retailers who are hoarding the limited produce. No doubt uneven distribution of rainfall has affected the farm produce. But the real reason for nearly 50% rise in prices of vegetables like tomato, onion and potato is not just that. The red tapism that disallows farmers from selling their produce directly to consumers is certainly to blame. In fact the Agricultural and Produce Market Committee allows them to sell the produce only to licensed middlemen.

These people in turn end up hoarding the produce, only to seek a higher price in times of shortage. That way the interest of both the framers and consumers get compromised. The RBI too has time and again criticized the government's policies in fixing higher minimum support prices (MSP). Thus, while the food inflation problem continues to ail Indian economy, the government seems to be more keen on earning votes through legislations like Food Security Bill.

 03:45
It appears that a new crisis in the Eurozone has been averted. Especially with respect to the economies of Portugal and Greece, which have been mired in recession for quite some time now. Borrowing costs in both these countries had surged in recent times. This was largely due to the fact that the political and economic climate had become unstable. In Portugal, the coalition government looked to be falling apart. And in Greece, the government was struggling to convince the EU and the IMF that it would be able to meet the terms of the bailout. But these issues seem to have been addressed.

Portugal has managed to patch things up. And Greece could reach a deal that would ensure that it continues receiving bailout funds. But does that mean that things are improving for the Eurozone? We believe not. All these are just short term fixes. None of them really address the structural issue of massive debt that these countries are burdened with. Thus, Portugal and Greece may have barely managed to keep their heads above water. But the possibility of another crisis lurking around the corner cannot be ruled out.

 04:35
In the meanwhile the Rupee's weakness weighed on the Indian equity markets today. At the time of writing, the Sensex was down by about 182 points (0.9%). Other Asian markets witnessed selling pressure too with markets in China and Indonesia leading the losses in the region.

 04:55 Today's investing mantra
"When you build a bridge, you insist that it can carry 30,000 pounds, but you only drive 10,000-pound trucks across it. And that same principle works in investing." - Warren Buffett

• Warren Buffett - The Value Investor

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11 Responses to "Should interest rates be raised to 17%?"

AJ

Jul 11, 2013

At least our nationalised banks are run by true banking professionals rather than engineer turned financial wizard straight from the B-Schools. Hence the common middle class who do the savings feel a little safe with their money in the banks.
On the note that why the banks are treated as culprits for bringing the growth rate down. The fact is the Government and our business community who are responsible for the current state of affairs. The Business community is not honest to pay the tax and the Government is so corrupt to conveniently close the eyes on the business community plus our great IAS/IPS/IRS and other various of our great three letter babus.

SANTOSH ARORA

Jul 9, 2013

THE RATES SHOULD NOT BE 17% BUT CUT DOWN TO EQUAL TO THE % OF USD WHICH IS LOWER THEN INDIAN RATES OF 9%. THIS CAN BE ACHEIVED BY:
1. INDIAN PEOPLE, INDIAN GOV, BANKERS, BUSINESS MAN & COURTS MUST BE HONEST.
2. LAND LAW MUST BE APPLIED TO ALL INRESPECT TO CAST, CREED, INDIVIDUAL PERSO.
3. MINNIMUM TIME SHOULD BE SPENT IN THE COURTS TO GIVE THE RULINGS.
4. NO ONE SHOULD STAY IN JAIL MORE THEN 5 YEARS. THEY SHOULD BE EDUCATED ON HONESTY AS WELL TREATMENT HUMAN TO HUMAN ON EQUAL BASIS.
5. SALARIES OF HIGHEST RANK PEOPLE LIKE MINISTER, GOVT OFFICIALS, CO DIRECTORS, BANK MANAGERS MUST BE SLASHED BY 30% & NO MORE ANY PREIVILAGE. AS SALARY IS COVERD THEIR TRAVEL EXPENCES LIKE ANY OTHER EMPLOYEE.
6. NO OPTIONS FOR CO. DIRECTORS & PROFIT TO BE SHARED EQUALL WITH THE SHARE HOLDERS.30% OS PROFIT MADE SHOULD GO O THE WELFARE OF INDIAN PEOPLE FOR EDUCATION, WELFARE & FUNDS FOR FUTURE GENERATIONS.
7. ONLY PROJECTS WHICH BENEFITS TO INDIAN PEOPLE SHOULD BE UNDERTAKEN.
8. FARES OF TAVEL MUST BE REDUCED. THERE SHOULD BE NO CLASSES LIKE FIRST CLASS, BUSINESS CLASS AS WE ALL R HUMANS & OUR NEEDS R SAME
9. EDUCATION OF MAN BODIES SHOULD BE MUST IN SCHOOLS , COLLEGE & UNIVERSITIES. IF U DONOT PASS EDUCATION ON UR OWN BODIES SHOULD NOT BE GIVEN CERTIFICATE.
10. IF WE ALL KNOW OUR OWN BODY THEN WE CAN MAINTAIN A HEALTY BODY THEN LESS HOSPITALS, LESS TREATMENTS

c v krishnakumar

Jul 9, 2013

Unlike the Government, banks are run by professionals and factor all aspects while determining rates of interest. the FM would do well to set his own house in order and address pressing matters that are really cry out loud for his attention rather than pontificating to professionals. Cheap gimmicks like setting up a women's bank may give some photo ops but he ignores hard realities like the worsening inflation, disastrous current account dericit, the plummeting Rupee to the nation's peril. Time he got his act together. Only months to go and he would have missed the bus and be remembered if at all as a failure.

Kulwant Raj

Jul 8, 2013

Your assumption that the SOURCE of funding for banks to give out loans comes ONLY from deposits is WRONG (I'm tempted to use stronger language, but shall desist for the moment). I have no inclination or time to lecture you on how "Fractional Reserve System" of central banks like our very own RBI functions. Do some homework and find it out for yourself. And one appeal: before you publish, please show minimum respect for the intelligence & wisdom of your intended recipients.

monish gaur

Jul 8, 2013

third time lucky, naah, once bitten, twice shy, indians hopefully are not such big fools 2 give a 3rd chance to UPA,point is the writing was there on the wall as good as a reflection on the mirror, pity UPA did not gauge it. and now wth dollar at 61 or 62 or the future 66 those zillions abroad will only chnge the equation : if those zillions does not include the trillions, billions or millions of family A or B or C : find ways to get it back else these families will go up without an iota of the dosh stacked abroad.

C K Vaidya

Jul 8, 2013

a) Why the Govt bond rate should include expected growth rate is not clear.
b) If for any reason which is not clear to me, the bond rate has to cover both inflation and growth rate, then during the past 5-10 years including high growth years when Indian economy grew at 8-9%, the calculated bond rates still works out same, i.e. 14-15%. If, this was not the situation earlier, why should it be so now?
c) Banks are reluctant to reduce interest rates for 2 reasons, namely, high inflation and their high NPAs.

B.S.CHIMKOD

Jul 8, 2013

Yes I agree. The lending rate is very low and has no relation to the informal market rate of interest which is 2% per month.At present there is no lobby at present to put forward the case of depositors. Hence borrower is paying negative rate of interest to the bank

heena

Jul 8, 2013

It looks that economy has taken the hot drinks more than it digest. Their heads are wobbling like a drunkard.

MRK Gandhi

Jul 8, 2013

I am in total agreement that interest rates should be hiked to at least 12 to 15%. This will discourage consumption and bring down inflation. Including housing also the interest rates for future borrowers should be increased, this will bring down demand sharply. Whatever support government may give through banks, the same will be misused by the business class. Another thing government should do is to constitute "anti corruption tribunals" and increase levels of punishment, besides taking over properties both good and bad of corrupt persons.

J Thomas

Jul 8, 2013

You are quite right. Bank fixed deposits give negative real return. On top of that, they are taxed. Therefore, I don't put any money in bank fixed deposits.