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Interest rates: Favourable? - Views on News from Equitymaster
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  • Jul 2, 2003

    Interest rates: Favourable?

    It was June 25th, as the world awaited the decision of the Federal Reserve. And as expected, the Fed announced a further 25 basis points cut in interest rates, bringing the cost of borrowing down to levels not seen in the world’s largest economy in the last 45 years. However, the US markets did not respond to this cut in a positive manner, as they had expected a cut of 50 basis points! Despite its expectations of higher economic growth in the near term, The Fed was worried about a substantial fall in the already low inflation levels.

    This rate cut was followed by, once again as expected, a cut in interest rates in many world economies. The European Central Bank (ECB) cut its interest rates by a good 50 basis points to their lowest level in any eurozone country since the Second World War. Countries like Hong Kong and Taiwan reduced their interest rates by 25 basis points while Thailand followed with a 50 basis points cut. However, India was not among the ones to react to the Fed rate cut. However, the RBI continues to maintain its stand of a soft interest rate regime.

    India: Interest Rates
      Bank Rate PLR
    FY95 12.00 15.0
    FY96 12.00 16.5
    FY97 12.00 15.0
    FY98 10.50 14.0
    FY99 8.00 13.0
    FY00 8.00 12.5
    FY01 7.00 12.0
    FY02 6.50 12.0
    FY03 6.25 11.5
    Source: CMIE

    So, why is that the leading economies in the world, including India, are on a rate cut spree since the last couple of years? The primary objective is to boost investment in the economy. Increased investments would lead to creation of jobs, which would lead to higher income and spending power, thereby, kick starting economic growth. However, all over the world, despite the rate cuts, there has been an absence of a visible pick-up in investments.

    In India too, the lack of confidence is marring investment prospects. This is because investments are a factor of consumption demand, which has grown at a slower rate over the last five years. Despite a consistent fall in interest rates over the last five years, except for few goods like motorcycles and durables, consumption demand has been lackluster. This could be attributed to the fact that 70% of the Indian population that rely on agriculture for income have been the worst affected in the last five years in light of poor monsoons. To put things in perspective, actual rainfall as a percentage deviation from normal rainfall has been in the negative zone for four consecutive years till FY03 (Source: CMIE). However, there has been a recovery in investment demand in the last one year, as is evident from the rise in import of capital goods.

    Thus, going forward, more than anything else, investment activities need to show up in the economy. Investment in the economy comes from private sector, public sector or the government. Private sector, in general, is hesitant to invest at the current juncture (barring few sectors). Public sector undertakings are inefficient and it will take a while for them to come back into shape (As per CMIE, net profit margin of PSU manufacturing companies has remained in the negative zone for the last five years). The onus therefore, lies on the government. And the realisation has already filtered into increased investment by the government in the form of the road construction project. Atleast the start has been made and visible economic impact is already been felt across key commodity sectors like cement and steel.

    In the long-term, given the RBI’s bias towards a softer rate regime, interest rates are likely to remain favorable. Perhaps the area of concern is the poor fiscal situation of the country combined with the high dependence on crude oil (if oil exploration programme that is underway tastes success, import dependency could reduce noticeably). Otherwise, fundamentally speaking, favorable foreign exchange reserves and a manageable inflation level augurs well for the economy.



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