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RBI's 1% Rate Cut And Permanent Loss Of Capital

Mar 31, 2016

Three-year fixed deposits with State Bank of India fetch up to 7.5%. And you can expect similar returns on deposits at top private sector banks. If you rely on fixed deposits, you are pocketing a net return of about 1.5%.

I am sure most of you have got the math. But please bear with me as I try to correlate the negative interest rate crisis in Japan with a possible crisis for depositors in India...

Inflation at the consumer level is currently about 5.9% in India. (That's why depositors are fetching a net positive return of nearly 1.5%.) Now, RBI governor, Dr Rajan, has been under pressure the past few months to cut rates and cut them sharply. Given that the 5 April Monetary Policy Review may be his last, Dr Rajan may have to do his bit to please the government and stock markets.

It helps that a rate hike from the US Fed is some time away and that the inflation numbers are benign, at least for the time being. Therefore, a cut of 0.5% on the repo rate is almost a given.
But what if Dr Rajan decides to get adventurous and double the rate cut to 1%?

As Ajit Dayal, founder of Equitymaster, pointed out in his latest Honest Truth, there are enough reasons to make such a steep cut possible.

But for the depositor, it would make net returns on fixed deposits negligible. Would that prompt more depositors to park funds in banks?

If you asked that question to a depositor in Japan, he would rather keep his cash under the pillow than pay the bank to hold it. Interest rates in Japan are negative, after all.

But even if the RBI does cut rates, Indian depositors could still opt for the safety of bank deposits without having to pay for it. However, it seems Indian households already prefer to hoard cash rather than keep it at banks. I quite agree with Vivek Kaul’s views that a sharp rate cut could be dangerous for a country of savers.

The latest monthly Ecowrap from SBI shows that the currency with the public grew by 25% YoY from April 2015 to February 2016. If we correlate this data with the consumer inflation number, we see that in the past a sharp fall in inflation leads to a rise in household cash levels and vice versa.

Plus, as per RBI and SBI calculations, every 1% rise in currency with the public leads to 0.7% rise in the Index for Industrial Production (IIP). Therefore, more cash in the hands of consumers has had a direct and positive correlation to economic growth in the past.

However, the problem is that, this time, the rise in cash levels isn't due to a sharp fall in inflation. Nor has it been accompanied by an uptick in the IIP.

Of course, a lot more math and economic analysis is necessary to come to a concrete conclusion on this. But it's clear that Indian depositors are already wary of bank deposits and prefer to keep their cash elsewhere.

Indian households hoarding cash?

  Incremental currency (Rs bn) # Growth Consumer Price Inflation (%)
FY10 1,043   9.5
FY11 1,207 57% 6.5
FY12 836 -31% 11.1
FY13 853 2% 9.1
FY14 865 1% 5.9
FY15 1,052 22% 6.3
FY16 1,314 25% 5.9

Source: SBI, inflation.eu

A sharp cut in interest rates would put the depositor in a crisis of sorts. And we may see households hoarding cash without investing or spending it. Certainly not good symptoms for an economy aiming to grow at one of the fastest rates in the world.

The biggest myth: You might lose capital in stocks but not in your bank account

The problem with hoarding cash or keeping it in bank deposits fetching negligible returns is the myth that doing so keeps your savings safe.

Investors wary of volatility in stock markets etc prefer the 'safety' of assured returns in bank deposits. But they're unaware that even bank deposits involve significant investing risks.

Here is what Rahul Shah wrote a couple of months back:

  • But if not volatility then what is investing risk all about? Who better than the Oracle of Omaha himself to answer this question?

  • For Buffett, the risk is simply the possibility of a permanent loss of capital and has almost nothing to do with the volatility in a stock's earnings or its price! That's it. It is as simple as that.

  • One place where a permanent loss of capital shows up and goes unnoticed by most investors is the fight against inflation.

  • Say you want to set aside some money for your child's education which he will need when he turns 18.
  • If the cost of education goes up by 10% every year, there's no use investing the money in fixed deposits where returns won't exceed 8%-9% over the foreseeable future.

  • Doing this would mean a permanent loss of capital as the returns haven't kept pace with rise in cost of education. Therefore, a fixed deposit in this case is not a safe investment option but has actually proven to be risky!

Avoiding permanent loss of capital

The risk of fixed deposits is that they won't cover inflation. So they aren't the answer to avoiding permanent loss of capital.

Rather, in a scenario where real returns (adjusted for inflation) on bank deposits are set to go negative, it is more sensible to look for positive risk-adjusted returns elsewhere.

I am sure you have already guessed that I am referring to safe stocks.

And why not?

Safe stocks could give far more than the 10% return on capital. And despite all the talk about their volatility, stocks can actually be a much less risky option.

Remember: Risk doesn't come from the volatility of the underlying asset. It comes from the possibility of suffering a permanent loss of capital.Don't avoid stocks just because they're volatile. If we do a good job evaluating their fundamentals and valuations, stocks can actually be safe, lucrative long-term investments.
So how do you know which stocks have the core elements to avoid permanent loss of capital? By taking a closer look at long-term fundamentals. Investors must be wary of poor fundamentals, for they are the key reason for permanent loss of capital in stocks.

By the way, I hope you've had a chance to look at the 'Crash Score' report. It reveals a method to sift through thousands of stocks and weed out the most poisonous ones. In other words, it's a method that could be of great help in avoiding stocks that could result in a permanent loss of capital.

Please click here in case you haven't accessed to the guide yet.

Tanushree Banerjee

Tanushree Banerjee (Research Analyst), is the editor of Stock Select and, ValuePro Equitymaster's oldest recommendation services. She is also the editor of Equitymaster's most popular newsletter read by over 300,000 subscribers, The 5 Minute WrapUp. Tanushree started her career at Equitymaster covering the banking and financial sector stocks and scrutinising RBI policies. Over the last decade, she developed Equitymaster's research processes that helped us pick out various multibaggers, across all sectors. A firm believer of "safety first" when it comes to investing, Tanushree closely follows the investing philosophies of Warren Buffett, Jeremy Grantham, and Joel Greenblatt.


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