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What higher interest rates mean for you? - Views on News from Equitymaster
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  • Jul 31, 2000

    What higher interest rates mean for you?

    Whether the Reserve Bank of India (RBI) should have adopted such a harsh policy measure to stem a 3% decline in the value of a Rupee is debatable. But now that banks are actively considering raising rates its time to take a re-look at the implications of a rate hike.

    Warren Buffett, the Oracle of Omaha, is known for his investment decision-making capabilities. What better than one of Mr. Buffett’s statements to explain the effect of interest rates on the stock market? “If government interest rates, now at a level of about 6% were to fall to 3%, that factor alone would come close to doubling the value of common stocks”. Hardening of rates would, ofcourse, have the opposite effect. This would not augur well for stock markets.

    The government of India too would not be spared. The government's borrowing programme for the year FY01 has been pegged at approximately Rs 1,100 bn. With 40% of the programme complete, the 0.5% raise in rates would imply an increase of Rs 3.3 bn in annual servicing costs. Though marginal, it nevertheless adds to the fiscal burden. Higher deficits, over a period of time, could result in either higher taxes or slower government spending (say, for example on infrastructure).

    Business would be adversely affected. Borrowing for new investment projects would become more expensive. This would hurt investment activity, which in the manufacturing sector continues to decline. Higher interest rates would also raise servicing costs for working capital funds and floating rate loans, thus hurting corporate profitability.

    Individuals will get hurt in several ways. Servicing cost of debt raised for financing a house, car or durables will rise. Other effects would largely be as fallout on the stock markets and the government’s fiscal position.

    Just to complete the analysis, who would benefit? Save for a ‘temporary’ halt to depreciation in the value of the Indian Rupee, nothing much would flow in. Therefore imports, which presently are approximately 10% of would not suffer price inflation. To put this in perspective, 3% depreciation in the value of the Rupee would have a price impact of only 0.3%, which at worst is marginal.

    The RBI has built a creditable track record in recent years, and it is unlikely that they may have over reacted to the situation. However, presently the rate hike is adversely affecting most sections of the economy. Let’s hope the RBI has some trick up its sleeve.



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