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What should you do if interest rates go back to 14%? - Views on News from Equitymaster
 
 
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  • Jul 9, 2013

    What should you do if interest rates go back to 14%?

    Banks' lending rates are unlikely to head southwards anytime soon. Yes, the government is insisting that PSU banks unleash their generous streak. But we believe that the profit conscious banks will refrain from doing so. Banks are not just worried about losing their lending margins. Cutting deposit rates may even entail losing customers! For while inflation remains steady, lower deposit interest rates could mean negative real returns. Hence bank depositors may shy away from parking more money with them. Plus if and when the US Fed decides to take interest rates higher, Indian banks will compete with their foreign counterparts as well. It will be a challenge to retain foreign money. If the differential rate of interest between Indian and foreign bank deposit rates narrow too much, Indian deposits will lose their luster.

    The government's attempts at tacking the inflation problem have been hopeless to say the least! Hence, we will not be surprised if interest rates move back to higher double digits. Here we are referring to the benchmark lending rate for banks. It was earlier referred to as prime lending rate or PLR. Was rechristened to 'base rate' in 2010. Historically, i.e. from 1978 until 2013, India's PLR or base rate has averaged at around 14%. It touched an all time high of 20% in February 1992. Later it touched a record low of 8% in July 2010.

    The average benchmark lending rate of Indian banks currently is around 10.25%. What is the possibility of it moving higher? Vulnerability of food inflation and risk premium attached to Indian corporate could very well take the rate closer to the long term average.

    What should you do in such a scenario?

    • Be very very careful about debt investments...especially corporate debt Poorly managed banks and dubious corporate lose no time in luring investors with ridiculously high interest rates. Investors who lost money by investing in corporate debt during 2000 to 2002 would agree with us! As per a CRISIL 2006 report, 120 companies defaulted on their bond repayment obligations between 2002 and 2006. Even in 2011, the likes of Unitech, United Spirits and Jaypee Infratech offered interest rates as high as 11.5% on the deposits. Therefore, if interest rates on corporate deposits do move higher, investors need to get all the more choosy and careful. Instead of getting carried away by the promises, they need to check the potential risk to their capital. We are already seeing some ridiculous interest rates being offered on corporate deposits!

    • Do not sell ALL your stocks: High interest rate on fixed income securities is not an indication for investors to sell all their stocks. Only the ones with leverage, high capex plans or vulnerability to interest rate cycles need to be evaluated well.

    • Keep your loan obligation minimal: Needless to say investors need to keep their own exposure to loans minimal to avoid strain on cash flows.

    • Buy / Hold some gold: Last but not the least, investors must have a small portion of portfolio in gold. Gold is the ideal hedge against inflation and currency risks. Investors therefore should buy or hold a small proportion of their asset in gold, without worrying about short term price movements of the metal.
    Lastly, we cannot emphasize enough that you should be careful about your overall asset allocation. Exposure to debt, equities and gold cannot be without keeping aside some safe cash.

      Tanushree Banerjee (Research Analyst), is the editor of ValuePro, The India Letter, and Stock Select, Equitymaster's oldest recommendation service. She is also the editor of Equitymaster's most popular newsletter read by over 200,000 subscribers, The 5 Minute WrapUp. Tanushree started her career at Equitymaster covering the banking and financial sector stocks along with scrutinizing the RBI policies. And over the last decade, developed our research processes that have 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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