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

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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 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

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.

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.

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.

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.

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.

 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

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

    Srinivasa Murthy N S

    Jul 8, 2013

    I feel very sad that even an esteemed site like EQUITYMASTER is not concentrating on the devaluation of Rupee and not giving the due importance the critical issue deserves

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