Cut Interest Rates by 2 per cent: The New Economics of Nirmala Sitharaman - Vivek Kaul's Diary
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Cut Interest Rates by 2 per cent: The New Economics of Nirmala Sitharaman

Aug 25, 2016

28

BA Kiya Hai, MA Kiya,
Lagta Hai Wo Bhi Aiwen Kiya.
- Gulzar in Mere Apne

The commerce and industry minister Nirmala Sitharaman wants the Reserve Bank of India (RBI) to cut the repo rate by 200 basis points.

Yes, you read that right!

200 basis points!

The repo rate is the rate at which banks borrow from the RBI on an overnight basis. One basis point is one hundredth of a percentage. The repo rate currently stands at 6.5 per cent.

"I still hold that the cost of credit in India is high. Undoubtedly, particularly MSMEs which create a lot of jobs contribute to exports... are all hard pressed for money and for them, approaching a bank is no solution because of the prevailing rate of interest. I have no hesitation to say, yes 200 bps, I would strongly recommend," Sitharam told the press yesterday in New Delhi.

What Sitharaman was basically saying is that India's micro and small and medium enterprises(MSMEs) are not approaching banks for loans because interest rates are too high. Given this, the RBI should cut the repo rate by 200 basis points and in the process usher in lower interest rates for MSMEs.

This, according to Sitharaman, was important because MSMEs create a lot of jobs and contribute to exports, and hence, should be able to borrow at a lower interest rates, than they currently are. As per the National Manufacturing Policy of 2011, the small and medium enterprises contribute 45 per cent of the manufacturing output and 40 per cent of total exports.

Hence, Sitharaman was batting for the MSMEs. But is it as easy as that?

That politicians don't understand economics, or at least pretend not to understand it, is a given. But Sitharaman is a post graduate in economics from the Jawaharlal Nehru University in Delhi. (You can check it out here). For her, to make such an illogical remark, is rather surprising.

Not that the RBI is going to oblige her, but for a moment let's assume that it does, and cuts the repo rate by 200 basis points, in the next monetary policy statement, which is scheduled for October 4, 2016, or over the next few statements.

What is going to happen next? Will banks cut their lending rates by 200 basis points? Only, when the banks cut their lending rates by 200 basis points, is the MSME sector going to benefit.

Banks only borrow a small portion of money from the RBI on an overnight basis and pay the repo rate as interest. A major portion of the money that they lend is borrowed in the form of fixed deposits. Hence, lending rates cannot fall by 200 basis points, unless fixed deposit interest rates fall by at least 200 basis points. (I use the word at least because banks tend to cut deposit rates faster than lending rates).

Wil the banks cut deposit rates by 200 basis points? Let's assume that they do. If the deposit rates are cut by such a huge amount at one go, people will not save money in fixed deposits. Money will move into post office savings schemes, which offer a significantly higher rate of interest in comparison to fixed deposits (which they do even now, but with a cut the difference will be substantial).

Over a longer period of time, money will also move into real estate and gold, as people start looking for a better rate of return, higher than the prevailing inflation. This will lead to the financial savings of the nation as a whole falling. And banks in order to ensure that deposits keep coming in, will have to reverse the 200 basis points cut and start raising interest rates.

This is precisely how things played out between 2009 and 2013, when household financial savings fell from 12 per cent of the GDP to a little over 7 per cent of the GDP. Meanwhile, the interest rates went up, in order to attract financial savings.

This is Economics 101, which a post graduate in economics from a premier university in the country, should be able to understand.

Another important issue that our politicians seem to forget, over and over again, is the importance of fixed deposits, as a mode of saving, in an average Indian's life. In 2013-2014, the latest year for which data is available, 69.23 per cent of total household financial savings, were in deposits.

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Of this nearly 62.02 per cent was with scheduled commercial banks and 4.19 per cent with cooperative banks and societies. Nearly 2.61 per cent was invested in deposits of non-banking companies.

What does this tell us? It tells us that for the average Indian, the fixed deposit is an important form of saving. For the retirees it is an important form of regular income. Now what happens if fixed deposit interest rates are cut by 200 basis points? The regular income from the fresh money that retirees invest, will come down dramatically. Also, when their old fixed deposits mature, they will have to be invested at a significantly lower rate of interest.

This means that they will have to limit their consumption in order to ensure that they meet their needs from the lower monthly income that their fixed deposits are generating.

What about those who use fixed deposits as a form of saving? (I know that fixed deposits are a terribly inefficient way of saving, but that is really not the point here). Those who are using fixed deposits to save money, for their retirement, for the education and wedding of their children, will now have to save more money, in order to ensure that they are able to create the corpus that they are aiming at. This will also mean lower consumption.

Ultimately lower consumption will impact MSMEs as well, because there won't be enough buyers for what they produce, as people consume less.

Those individuals who are not in a position to save the extra amount in order to make up for lower interest rates, will end up with a lower corpus in the years to come.

The point being that MSMEs do not operate in isolation. And the level of interest rates impacts the entire economy and not just the MSMEs, as Sitharaman would like us to believe.

Further, even if fixed deposit rates fall by 200 basis points, banks may still not be able to offer low interest rates to MSMEs, simply because they need to charge a credit risk premium i.e. factor in the riskiness of the loan that they are maing.

In case of the State Bank of India, the gross non-performing assets of SMEs stands at 7.82 per cent, as on March 31, 2016. This means that for every Rs 100 that the bank has lent to an SME, close to Rs 8 has been defaulted on. This risk of default needs to incorporated in the interest rate that is being charged.

And finally, the interest rates on fixed deposits of greater than one year are currently in the region of 7 to 7.5 per cent. This is when the rate of inflation has already crossed 6 per cent. In July 2016, the rate of inflation as measured by the consumer price index was at 6.07 per cent.

If fixed deposit rates are cut by 200 basis points, the interest rates will fall to around 5 to 5.5 per cent. This when the rate of inflation is greater than 6 per cent. This would mean that the real rate of interest (the difference between the nominal rate and the rate of inflation) would be in a negative territory. This is precisely how things had played out between 2009 and 2013 and look at the mess it ended up creating for the Indian economy.

Given these reasons, it is best to say that Sitharaman's prescription would be disastrous for the Indian economy.

Vivek Kaul is the Editor of the Diary and The Vivek Kaul Letter. Vivek is a writer who has worked at senior positions with the Daily News and Analysis (DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. The latest book in the trilogy Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System was published in March 2015. The books were bestsellers on Amazon. His writing has also appeared in The Times of India, The Hindu, The Hindu Business Line, Business World, Business Today, India Today, Business Standard, Forbes India, Deccan Chronicle, The Asian Age, Mutual Fund Insight, Wealth Insight, Swarajya, Bangalore Mirror among others.

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17 Responses to "Cut Interest Rates by 2 per cent: The New Economics of Nirmala Sitharaman"

VISHNU R PATEL

Aug 28, 2016

Very bold & balance analyst view for nation economy & social unsecured sinior citizens.....politicians view only shortcut & selfish thinks(industry bad loans issued scandal ...?.. thinks ?.? against social saving public money).....only mu(o)divaadi thinks no require against social economic security

Like 

RAJENDRA KUMAR

Aug 26, 2016

Dear Mr. Vivek Kaul,
Sir You research in economy related areas are really marvelous and embedded with real supporting data which not only easily graspable but also able to see inside. You are really doing very good Job without any hesitation and fear which ultimately benefited society. You are doing job like Hero as Dr. B.R. Ambedkar who shows real mirror to the people.

Like (1)

KD

Aug 26, 2016

This is the basic fact of economics that the reduction in Interest Rates increases demand in the economy. If you disagree with this fact then probably you should get noble prize in economics.

Interest rate is so high that no one is willing to invest. This is evident from the state of capital goods sector. Moreover, according to article published in economic times, Indian industry is facing deepest earning decline in 20 years.

If these is no investment, then there will be no jobs. Moreover, companies will close loss making units and millions jobs will be lost.

This will create a chaos in country like India where there is very high percentage of young population. On the top of that one of the commenter who holds PhD is condemning business persons. This will anyway result in extreme leaders coming to power. Therefore, it will be prudent for business people to start investing in the countries that are business friendly.

Also, why can't senior citizens invest in equity or any other asset class to earn the same returns. It seems these people want high interest rate with no risk!!!!

Like (1)

Prasad

Aug 26, 2016

All these people think that interest rates is the ONLY stumbling block in India's growth. They conveniently forget that reducing inflation is in the hands of businessmen only. IF they reduce artificially high prices of commodities and services, inflation will automatically reduce resulting in lower interest rates.

Also those who always point out that rates are very high in India as compared to developed world, they should realize that inflation is also very high in India. Developed countries inflation is almost non-existent. Also so many years of low rates has not added much to their GDPs.

Like (1)

E Vishwa Nathan

Aug 26, 2016

The write up fully reflects my fears, a 75 year old retiree from private service who is fully dependent on the FD interest income for maintenance. Already, the reduction of FD interest from 9.5% to 8% in the last two years on the one side and the increase in the cost of living on the other side is making life difficult for me. I hope the Hon. Minister's suggestion, which is anti middle class, is strongly opposed by all.

Like (1)

vip

Aug 26, 2016

Is JNU distributing degrees in economics without checking the basic knowledge of the candidate ?

Like (1)

M K Rathi

Aug 26, 2016

Would like to understand that why when interest rates are close to zero in usa n japan why are they not sending billions to put into indian fixed deposit or are there any limitations set by Goi.

Would tds removal from fixed deposits help the aged and retirees

Why is that the spread betwen lending rates and fixed deposit rates is so high in india,..just because we need to pamper our hardly 1 to 2 million psu bank employees, does india need to be shackled...?

Like (1)

Rama

Aug 25, 2016

Vivek,

Thanks for the nice article.. Infact she shud have asked for funding at negative rates.. Add to this the recommendation on AT-1 bond investments by the Khan committee on developing the Indian bond market (published on August 25, 2016 on RBI site)..It is shocking that the committee members are considering the coupon of 11.95% on AT-1 bonds as very high and prohibitive(rated below investment grade and issued by an highly inefficient PSU bank) and making recommendation that IRDA /PFRDA / EPFO must liberalize their investment norms so that banks can get more bakaras for their coco bonds and banks can continue to lend and accumulate more NPAs..

It is a matter of time that banks will not have any depositors nor will find any buyers for their Basel III bonds and probably be out of business..

Like (2)

v.vidyanath sastry

Aug 25, 2016

Nirmala Seetharaman is nuts.It is better she concentrates on exports which are falling by continuously ever since she took over.

Like (2)

yogendra pal singh sirohi

Aug 25, 2016

In past more than 2 years she was not heard except routine of her ministry.Certainly she is not having holistic view of Indian economy.Academic brilliance is no guaranty of grasp of ground facts.Her recommendation proves the point.I knew this on twitter today and was aghast.
God knows if it is her own view or some one else influenced her. Political pressures on R.B.I. governors are
known,but not in this manner.
y.p.singh

Like (2)
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