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On This Day - 8 JULY 2013
Should interest rates be raised to 17%?
In this issue:
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?
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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.
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.
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.
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