Mr FM, interest rates in India should be at least 17%

On July 3, 2013, the finance minister P Chidambaram asked government public sector banks to cut interest rates. There was nothing new about the finance minister’s diktat. He has asked public sector banks to cut interest rates, several times in the recent past. “Reduction in base (or floor) rate will be a powerful stimulus to boost credit growth,” said Chidambaram.
In a statement made today(July 5, 2013) D Subbarao, the governor of the Reserve Bank of India, came out in support of Chidambaram. “When RBI cuts interest rates, expectation is that monetary transmission will take place and banks would respond. Some have responded and some haven’t,” Subbarao said. What Subbarao meant in simple English was that when RBI cuts interest rates, the expectation is that banks will also cut interest rates on loans.
But interest rates in India are much lower than they should be given the rate of consumer price inflation and the rate of economic growth. This is one of the well kept secrets of Indian banking.
The return on a 10 year
government bond as of now is around 7.4%. A 10 year government bond is a bond sold by the Indian government to finance its fiscal deficit or the difference between what it earns and what it spends.
Anyone investing in a bond basically looks at three things: the expected rate of inflation, the expected rate of economic growth and some sort of risk premium to compensate for the risk of investing in the bond. These numbers are added to come up with the expected return on a bond.
The consumer price inflation
in the month of May 2013 stood at 9.31%. As per most forecasts the Indian economy is expected to grow at anywhere between 5-6% during this financial year (i.e. the period between April 1, 2013 and March 31, 2014).
Lets assume that lending to the Indian government is considered to be totally risk free and hence consider a risk premium of 0%. Also to keep things simple, lets assume a consumer price of inflation of 9% and an expected economic growth of 5.5% during the course of the year. When we add these numbers we get 14.5%.
This is the rough return that a 10 year Indian government bond should give. But the return on it is around 7.4% or half of the projected 14.5%.
Why is that the case? The reason for that is very simple. Indian banks need to maintain a statutory liquidity ratio of 23% i.e. for every Rs 100 that a bank raises as a deposit, it needs to compulsorily invest Rs 23 in government bonds.
Hence, banks(and in turn citizens) are forced to lend to the government. Similarly, Life Insurance Corporation of India also invests a lot of money in government bonds. So there is a huge amount of money that gets invested in government bonds. This ensures that returns on government bonds are low in comparison to what they would really have been if people and banks were not forced to lend to the government.
The return on government bonds acts as a benchmark for interest rates on all other kind of loans. This is because lending to the government is deemed to the safest, and hence the return on other loans has to be greater than that, given the higher risk.
The 10 year bond yield or return is currently at 7.4%. The average base rate for banks or the minimum rate a bank is allowed to charge to its customers, is around 10.25%. So most loans are made at rates of interest higher than 10.25%. The difference between the 10 year bond yield and the average base rate of banks is around 285 basis points (one basis point is one hundredth of a percentage).
If the 10 year bond yield would have been at 14.5%, then the interest rates on loans would have been greater than 17%(14.5% + 285 basis points). But since the government forces people to lend to it, the interest rates are lower. This act of the people being forced to lend to the government is referred to as financial repression.
Economist Stephen D King in his book
When the Money Runs Out makes an interesting point about financial repression in the context of western economies. As he writes “our savings will increasingly be diverted to government interests, whether or not those interests really deliver a good rate of return for society.”
While this may happen in the Western societies as governments resort to financial repression to repay the huge amounts of debt that they have accumulated, it is already happening in India.
Financial repression is a major reason behind the Congress led United Progressive Alliance (UPA) government going in for a large number of harebrained social programmes (the most recent being the right to food security, which has been brought in through the ordinance route). They know that money required for all these programmes can easily be borrowed because 23% of all bank deposits need to be invested in government bonds issued to finance the excess of government expenditure over revenue.
This is also why interest rates offered on bank fixed deposits are close to the rate of consumer price inflation, leading to a zero per cent real rate of return on investment. This is also makes people buy gold and real estate and invest in Ponzi investment schemes, in search of a higher rate of return. The cost of financial repression is being borne by the citizens of this country.

Also, the idea behind Chidambaram’s call for lower interest rates is that people are likely to borrow and spend more. And this in turn will get economic growth going again. Theoretically this just sounds perfect.
But then theory does not always match practice. Banks raise deposits at a certain rate of interest and then give out loans at a higher rate of interest. So unless the interest rate offered on deposits goes down, the rate of interest charged on loans cannot come down.
Banks are not in a position to cut interest rates on deposits as of now (
As I have explained here). Hence, it is not possible for them to cut interest rates on loans. Any bank which cuts interest rates on loans will essentially end up with lower profits.
Also even if interest rates on loans are cut, it may not lead to people borrowing and spending money. There are several reasons for the same. Lets first consider car loans.
Car sales have fallen for the last eight months in comparison to the same period during the year before. High interest rates are a reason offered time and again for slowing car sales. But some simple maths tells us that can’t really be the case.
Lets consider the case of an individual who borrows Rs 5 lakh to buy a car at an interest rate of 12% repayable over a period of 7 years. The equated monthly instalment for this works out to Rs 8826. Lets say the bank is able to cut the interest rate by 0.5% to 11.5%. In this case the EMI works out to Rs 8693, or Rs 133 lower. Even if the bank cuts interest rates by 1%, the EMI goes down by Rs 265 only. If we consider a lower repayment period of 5 years, an interest rate cut of 0.5% leads to an EMI cut of Rs 126. An interest rate cut of 1% leads to an EMI cut of Rs 251. The point is that no one is going to go buy a car because the EMI has come down by a couple of hundred rupees.
This is something the people who run car companies seem to understand.
As Arvind Saxena, managing director, Volkswagen Passenger Cars, told DNA in an interview carried out in late January 2013 “Fundamentally nothing has changed that should really prop up sales. If interest rates go down by 25 or 50 basis points, it doesn’t change anything overnight.”
RC Bhargava, a car industry veteran and the Chairman of 
Maruti Suzuki India was more vociferous than Saxena of Volkswagen when he told Business Standard in a recent interview “In India, over 70 per cent of car purchases are financed by banks. An interest rate reduction of, say, one percentage point doesn’t change a person’s decision of buying or not buying a car…With the uncertainties prevalent today, a consumer does not know what his job would be like after a year – whether or not he will have an incremental income, or even a job.”
Of course when people are not buying cars, it is unlikely they will buy homes, unless we are talking about those who have to put their black money to use. A cut in interest rates will bring down EMIs significantly on home loans. But even with lower EMIs people are unlikely to buy homes. This is because the cost of homes especially in cities has gone up big time making them totally unaffordable for most people.
The broader point is that just asking banks to cut interest rates doesn’t make any sense without trying to address the other issues at play.

The article originally appeared on on July 5, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

Of Subbarao, inflation, gold and Saradha scam

Central bank governors rarely indulge in any plain speak. You have to always read between the lines to understand what they are really saying. They never say what they mean. And they never mean what they say.
But D Subbrarao, the governor of the Reserve Bank of India, indulged in some plain speaking on Wednesday and questioned the logic of the Mamata Banerjee government in West Bengal setting up a Rs 500 crore relief fund to compensate the losses of those people who had invested in deposits raised by the Saradha Group in West Bengal.
A part of this relief fund will be funded by a 10% tax on cigarettes and the rest of the money will be raised through other sources. “If you go back to the West Bengal Saradha scheme, the Chief Minister said ‘I will levy additional taxes on cigarettes and some other things to compensate the people who have lost money’ … Is it fair?” Subbarao asked.
Why should people who smoke fund those whose money has gone up in smoke, is a reasonable question to ask. It is like robbing Peter to pay Paul.
Subbarao also dwelled into why Ponzi schemes like Saradha have become fairly popular. “The reason it (the Ponzi schemes) is happening because ordinary people… the low income people are not sufficiently aware of where they can put their money. They don’t have enough avenues to put their money. They can’t get into the banks like we all do. They face both formal and informal barriers…So they fall prey to these fraudulent schemes,” Subbarao explained.
This is an explanation similar to the one his deputy
K C Chakrabarty had come up with a few days back when he said: “The need of the hour is to ensure that our unbanked population gains access to formal sources of finance, their reliance on informal channels and on the shadow banking system subsides and, in the process, consumer exploitation is curbed.”
This is a very one-dimensional explanation of why Ponzi schemes have become so popular in India in the last few years. Ponzi scheme is a fraudulent investment scheme where the money being brought in by newer investors is used to pay off older investors. The scheme offers high returns and it keeps running till the money being brought in by the newer investors is greater than the money needed to pay off the older investors whose investment is up for redemption. The moment this breaks, the scheme collapses.
This writer has explained in the past that lack of a bank in their neighbourhood is not a reason good enough to explain why people invest money in Ponzi schemes. Many of the Ponzi schemes over the last few years have been very popular in urban as well as semi-urban areas, where there are enough number of banks going around. At the same time some of the Ponzi schemes have even needed bank accounts to ensure participate. So saying that people invest in Ponzi schemes because there are not enough banks going around, is not good enough. There are other bigger factors at work.
Ponzi schemes have become a big menace in India over the last few years. There numbers have gone up many times over. While there is no hard data to support the claim, but there is enough anecdotal evidence going around. Be it Speak Asia or Stock Guru or MMM India or Emu Ponzi schemes etc, there has been endless list of Ponzi schemes hitting the market.
This has also been a period of high inflation where interest offered on fixed deposits and postal savings deposits, has been very low or even negative once it is adjusted for inflation. There are other reasons as well why people find fixed deposits and postal savings deposits unattractive.
As Ila Patnaik wrote in a recent column in The Indian Express “Even those who have access often find it unattractive. Interest rates paid to depositors have been pushed down through years of policies of administered interest rates and lack of competition in banking. Regulatory requirements for priority sector lending and holding of government bonds have further resulted in lower returns. The result is low or negative real interest rates for depositors.”
It has been an era where bank fixed deposits have offered around 9% interest before tax when the inflation has been at 10% or more. The returns from post office savings deposits have been even lower than bank fixed deposits. Hence, in the strictest sense of the term, money deposited in banks or post office, has essentially been a losing proposition, given the high inflationary scenario that has prevailed.
And not surprisingly in this situation people have been looking at other investment avenues where there is a prospect of making higher returns. Gold has been one such investment avenue. As the
Economic Survey released by the government in late February this year pointed out “Gold imports are positively correlated with inflation. High inflation reduces the return on other financial instruments… This observation, in line with global trends, is easily explained by the declining real returns on the gamut of financial instruments available to the investor and soaring ones on gold (23.7 per cent annual average return between April 2007 – March 2012 versus 7.3 per cent return on Nifty and 8.2 per cent on savings deposits).”
So money came into gold because there was a prospect of earning a high real return instead of bank and post office deposits where the individual would have actually lost money after adjusting for high inflation.
A similar explanation can be offered for people investing their hard earned money in Ponzi schemes like Saradha. They were looking for a higher return which helped them at least beat the rate of inflation. And this is where Ponzi schemes like Saradha came in. These schemes offered deposits which promised higher returns than bank or post office deposits.
As an article in the Business Standard pointed out “Sen(in reference to Sudipta Sen who ran Saradha) offered fixed deposits, recurring deposits and monthly income schemes. The returns promised were handsome. In fixed deposits, for instance, Sen promised to multiply the principal 1.5 times in two-and-a-half years, 2.5 times in 5 years and 4 times in 7 years. High-value depositors were told they would get a free trip to “Singapur”.”
In case of Saradha, the credibility it had built through its media empire as well as being seen closely aligned to the ruling Trinamool Congress, also helped. The deposits being raised may have even been seen as very safe, by those investing.

The other thing that has happened over the last few years is that household savings have come down. In 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010), savings stood at 25.2% of the gross domestic product (GDP). In 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012) the savings had fallen by nearly three percentage points to 22.3% of the GDP.
This has primarily happened because of high inflation which has pushed up expenditure as a proportion of total income. But incomes haven’t gone up at the same pace. And this has led to a fall in savings.
Given that savings of people have come down, there might be a temptation to invest them in avenues where they thought a higher return could be earned so as to ensure that investment goals continue to be on track, even with a lesser amount of savings being invested. This might have increased people’s appetite for taking on investment risk.
Hence, high inflation may have had a big role to play in people investing their money in Ponzi schemes. And we all know who is to be blamed for that.
Inflation has had Subbarao worried for a while now. “There is an important constituency in the country that is hurt by inflation. Their voice also needs to be heard. It is the responsibility of public policy institutions like the Reserve Bank to go out of our way and listen to silent voices,” the RBI governor said on Wednesday.
To conclude, it is very easy to argue that more Ponzi schemes spread because people people lack access to basic banking. But the reality is a little more complicated than that. As they say, truth is often stranger than fiction.
The article originally appeared on on May 9,2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)


RBI may cut rates, but your loan rates may not fall


Vivek Kaul
The monetary policy review of the Reserve Bank of India(RBI) is scheduled for March 19,2013 i.e. tomorrow. Every time the top brass of the RBI is supposed to meet, calls for an interest rate cut are made. In fact, there seems to be a formula that has evolved to create pressure on the RBI to cut the repo rate. The repo rate is the interest rate at which RBI lends to banks.
The formula includes the finance minister P Chidambaram giving statements in the media about there being enough room for the RBI to cut interest rates. “There is a case for the Reserve Bank of India (RBI) to cut policy rates, and the central bank should take comfort from the government’s efforts to cut the fiscal deficit,” Chidambaram told the Bloomberg television channel today.
Other than Chidambram, an economist close to the Prime Minister Manmohan Singh also gives out similar statements. “The budget has also gone a long way in containing the fiscal deficit, both in the current year and in the following year, and played its role in containing demand pressures in the system. Therefore, in some sense there is greater space for monetary policy now to act in the direction of stimulating growth,” C Rangarajan, former RBI governor, who now heads the prime minister’s economic advisory council, told The Economic Times. What Rangarajan meant in simple English was that conditions were ideal for the RBI to cut interest rates.
And then there are bankers (most those running public sector banks) perpetually egging the RBI to cut interest rates. As an NDTV storypoints out “A majority of bankers polled by NDTV expect the Reserve Bank to cut interest rates in the policy review due on Tuesday. 85 per cent bankers polled by NDTV said the central bank is likely to cut repo rates.”
Corporates always want lower interest rates and they say that clearly. As a recent Business Standard story pointed out “An interest rate cut, at a time when demand was not showing any sign of revival, would boost sentiments, especially for interest-rate sensitives like the car and real estate sectors, which had been showing negative growth, a majority of the 15 CEOs polled by Business Standard said.”
So everyone wants lower interest rates. The finance minister. The prime minister. The banks. And the corporates.
Lower interest rates will create economic growth is the simple logic. Once the RBI cuts the repo rate, the banks will also pass on the cut to their borrowers. At lower interest rates people will borrow more. They will buy more homes, cars, two wheelers, consumer durables and so on. This will help the companies which sell these things. Car sales were down by more than 25% in the month of February. Lower interest rates will improve car sales. All this borrowing and spending will revive the economic growth and the economy will grow at higher rate instead of the 4.5% it grew at between October and December, 2012.
And that’s the formula. Those who believe in the formula also like to believe that everything else is in place. The only thing that is missing is lower interest rates. And that can only come about once the RBI starts cutting interest rates.
So the question is will the RBI governor D Subbarao oblige? He may. He may not. But the real answer to the question is, it doesn’t really matter.
Repo rate at best is a signal from the RBI to banks. When it cuts the repo rate it is sending out a signal to the banks that it expects interest rates to come down in the days to come. Now it is up to the banks whether they want to take that signal or not.
When everyone talks about lower interest rates, they basically talk about lower interest rates on loans that banks give out. Now banks can give out loans at lower interest rates only when they can raise deposits at lower interest rates. Banks can raise deposits at lower interest rates when there is enough liquidity in the system i.e. people have enough money going around and they are willing to save that money as deposits with banks.
Lets look at some numbers. In the six month period between August 24, 2012 and February 22, 2013 (the latest data which is available from the RBI) banks raised deposits worth Rs 2,69,350 crore. During the same period they gave out loans worth Rs 3,94,090 crore. This means the incremental credit-deposit ratio in the last six months for banks has been 146%.
So for every Rs 100 that banks have borrowed as a deposit they have given out Rs 146 as a loan in the last six months. If we look at things over the last one year period, things are a little better. For every Rs 100 that banks have borrowed as a deposit, they have given out Rs 93 as a loan.
What this clearly tells us is that banks have not been able to raise enough deposits to fund their loans. For every Rs 100 that banks borrow, they need to maintain a statutory liquidity ratio of 23%. This means that for every Rs 100 that banks borrow at least Rs 23 has to be invested in government securities. These securities are issued by the government to finance its fiscal deficit. Fiscal deficit is the difference between what the government earns and what it spends.
Other than this a cash reserve ratio of 4% also needs to be maintained. This means that for every Rs 100 that is borrowed Rs 4 needs to be maintained as a reserve with the RBI. 
So for every Rs 100 that is borrowed by the banks, Rs 27 (Rs 23 + Rs 4) is taken out of the equation immediately. Hence only the remaining Rs 73 (Rs 100 – Rs 27) can be lent. This means that in an ideal scenario the credit deposit ratio of a bank cannot be more than 73%. But over the last six months its been double of that at 146% i.e. banks have loaned out Rs 146 for every Rs 100 that they have raised as a deposit.
So how have banks been financing these loans? This has been done through the extra investments (greater than the required 23%) that banks have had in government securities. Banks are selling these government securities and using that money to finance loans beyond deposits.
The broader point is that banks haven’t been able to raise enough deposits to keep financing the loans they have been giving out. And in that scenario you can’t expect them to cut interest rates on their deposits. If they can’t cut interest rates on their deposits, how will they cut interest rates on their loans?
The other point that both Chidambaram and Rangarajan harped on was the government’s effort to cut/control the fiscal deficit. The fiscal deficit for the current financial year (i.e. the period between April 1, 2012 and March 31,2013) had been targeted at Rs 5,13,590 crore. The final number is expected to come at Rs 5,20,925 crore. So where is the cut/control that Chidambaram and Rangarajan seem to be talking about? Yes, the situation could have been much worse. But simply because the situation did not turn out to be much worse doesn’t mean that it has improved.
The fiscal deficit target for the next financial year (i.e. the period between April 1, 2013 and March 31, 2014) is at Rs 5,42,499 crore. Again, this is higher than the number last year.
When the government borrows more it “crowds out” and leaves a lower amount of savings for the banks and other financial institutions to borrow from. This leads to higher interest rates on deposits.
What does not help the situation is the fact that household savings in India have been falling over the last few years. In the year 2009-2010 (i.e. the period between April 1, 2009 and March 31, 2010) the household savings stood at 25.2% of the GDP. In the year 2011-2012 (i.e. the period between April 1, 2011 and March 31, 2012) the household savings had fallen to 22.3% of the GDP. Even within household savings, the amount of money coming into financial savings has also been falling. As the Economic Survey that came out before the budget pointed out “Within households, the share of financial savings vis-à-vis physical savings has been declining in recent years. Financial savings take the form of bank deposits, life insurance funds, pension and provident funds, shares and debentures, etc. Financial savings accounted for around 55 per cent of total household savings during the 1990s. Their share declined to 47 per cent in the 2000-10 decade and it was 36 per cent in 2011-12. In fact, household financial savings were lower by nearly Rs 90,000 crore in 2011-12 vis-à-vis 2010-11.”
While the household savings number for the current year is not available, the broader trend in savings has been downward. In this scenario interest rates on fixed deposits cannot go down. And given that interest rate on loans cannot go down either.
Of course bankers understand this but they still make calls for the RBI cutting interest rates. In case of public sector bankers the only explanation is that they are trying to toe the government line of wanting lower interest rates.
So whatever the RBI does tomorrow, it doesn’t really matter. If it cuts the repo rate, then public sector banks will be forced to announce token cuts in their interest rates as well. Like on January 29,2013, the RBI cut its repo rate by 0.25% to 7.75%. The State Bank of India, the nation’s largest bank, followed it up with a base rate cut of 0.05% to 9.7% the very next day. Base rate is the minimum interest rate that the bank is allowed to charge its customers.
A 0.05% cut in interest rate would have probably been somebody’s idea of a joke. The irony is that the joke might be about to be repeated in a few day’s time.
The article originally appeared on on March 18,2013. 

(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why an increase in tax break won’t make people buy more homes

Vivek Kaul
It is time of the year when tax saving stories start to make it to the front page of newspapers, as the finance minister gets ready to present the annual budget of the government of India.
Today’s edition of The Hindustan Times has one such a story according to which the “the government is considering hiking the tax deduction limit on home loan interest from the present Rs 1.5 lakh to more than Rs 2 lakh per annum.”
The story goes on to quote an expert to state that this increase in tax deduction will lead to an “increase the demand for housing units and have a multiplier effect on the economy through increased demand for steel, cement and labour.”
This is what we call kite flying of the highest order. Lets try and understand why.
Currently a deduction of upto a maximum of Rs 1.5 lakh is allowed for interest paid on a home loan. At the highest tax level of 30.9% (30% tax + 3% education cess) this means a tax saving of Rs 46,350 (30.9% of Rs 1,50,000).
Now let us say this is increased to Rs 2 lakh. At the highest tax level of 30.9% this would mean a tax saving of Rs 61,800 (30.9% of Rs 2,00,000). This implies an increased tax saving of Rs 15,450 per year (Rs 61,800 minues Rs 45,350) or Rs 1287.5 per month.
So basically what The Hindustan Times story really tells us is that people of this country will buy homes because they will save Rs 1287.5 more every month. But what it does not tell us is the amount of money they will have to spend to get this extra tax saving.
Let me throw more numbers at you. The story points out “The average home loan size has grown from about Rs 17 lakh about three years ago to close to Rs 22 lakh currently.” Let us consider a 20 year home loan of Rs 22 lakh taken at an interest rate of 10% (the actual home loan interest rates might be higher currently though).
The EMI (equated monthly instalment) on this loan would be Rs 21,230.48. Hence to get an extra tax deduction of Rs 1287.5 per month any individual taking a home loan would have to first spend Rs 21,230.48 which is 16.5 times more.
I guess people of India are clearly more intelligent than that. And I don’t see many people doing that.
People don’t buy homes to get a tax deduction. The average middle class Indian buys a home to stay in it. And for that to happen a couple of things need to happen. First and foremost real estate prices need to come down because only then will EMIs become affordable.
As The Hindustan Times story points out that three years back the average home loan size was Rs 17 lakh and now it is Rs 22 lakh. This has happened because home prices have gone up since then.
A home loan of Rs 17 lakh at an interest of 10% for a period of 20 years would mean an EMI of Rs 16,405.37. Hence, EMIs have gone up by around 29.4% in the last three years. And that makes it difficult for individuals looking to buy a home to live in.
The difference between the EMIs on a home loan of Rs 22 lakh and a home loan of Rs 17 lakh is around Rs 4825. This is 3.75 times more than the extra tax saving of Rs 1287.5 that would happen when the tax deduction limit on home loan interest goes upto Rs 2 lakh per year from the current Rs 1.5 lakh.
Also to get a bigger home loan one needs a higher income as well. Hence, an income required to get a Rs 22 lakh home loan is higher than the income required to get a Rs 17 lakh home loan.
So for people to start buying homes to live in real estate prices need to fall from their current atrocious levels. Whether that happens remains to be seen. As my paternal grandfather told me late last evening “roti kapda aur makaan ka daam kabhi nahi girta. (The price of food, clothes and houses never falls).”
The second thing that needs to happen for sales of homes to pick up is a fall in interest rates. At an interest rate of 8%, a 20 year home loan of Rs 22 lakh would imply an EMI of Rs 18,401.68. This would imply a lower EMI of Rs 2828.8 than at the 10% level.
In fact I have made all the calculations at the highest rate of tax of 30%. At lower rates of tax it makes even less sense to buy a home to get an extra tax deduction. Also, the average home loan in cities is obviously higher than the Rs 22 lakh used here. In cities, it is highly unlikely one would be able to buy anything for that kind of home loan value. Hence, the argument holds even greater value for cities where prices are much higher.
To conclude, the real estate market in India has been taken over by speculators looking to put their black money to some use. And currently it is these speculators playing a game of passing the parcel among themselves. Unless that breaks people won’t start buying homes, higher tax deductions notwithstanding.

This article originally appeared on on February 4, 2013
(Vivek Kaul is a writer. He can be reached at [email protected]

Banks would rather lend to govt than give you cheaper loan

Vivek Kaul
The State Bank of India (SBI) cut its base rate by 5 basis points (i.e. 0.05%, one basis point is one hundredth of a percentage) to 9.7% in response to the Reserve Bank of India (RBI) cutting the repo rate by 25 basis points (i.e. 0.25%). Guess it was their idea of a ‘bad’ joke. Repo rate is the interest rate at which the RBI lends to banks.
While newspapers have gone to town trying to tell you and me that interest rates are falling nothing like that has happened. A few banks have cut their auto loan rates but no major bank(other than SBI) has cut its base rate. Base rate is the lowest rate of interest at which a bank can lend.
Why has that been the case? Numbers tell a really interesting story.
As on March 30, 2012, banks had invested 28.55% of their deposits in government bonds. This number has since gone up and as on January 11, 2013, banks had invested 30.23% of their deposits in government bonds.
This means that during the course of this financial year (i.e. the period between April 1, 2012 and March 31, 2013) the Indian banks have invested a greater proportion of the deposits they managed to raise into government bonds.
The government issues bonds to finance its fiscal deficit. Fiscal deficit is the difference between what the government earns and what it spends.
What is interesting is that banks have to maintain a statutory liquidity ratio of 23% i.e. invest Rs 23 of every Rs 100 raised as demand and time deposits compulsorily into government bonds. But as of January 11, 2013, for every Rs 100 collected as deposits, banks had Rs 30.23 invested in government securities. And this has gone up from Rs 28.55 as on March 30, 2012. This in a scenario where banks need to invest only Rs 23 out of every Rs 100 raised as deposits in government bonds.
This tells us that banks would rather lend more to the government than you and me. This excess money chasing government bonds has led to a situation where the return on government bonds has fallen. The return on a 10 year government bond as on March 30, 2012, stood at 8.54%. On January 11, 2013, it was at 7.87%.
This excess lending and lower returns on the government portfolio has meant that banks need to continue charging high interest rates on the loans they make to consumers, in order to continue maintaining their profit levels. And that explains to a large extent why they haven’t cut interest rates despite the Reserve Bank cutting the repo rate by 0.25%.
The question to ask here is why are banks happy lending to the government rather than you and me? Is it a lazy banking? Why bother lending to individual consumers when you can lend in bulk to the government? Or are banks facing more losses on their lending and hence are sticking to lending to the government? Lending to the government is deemed to be safe given that even in the worst possible scenario the government can always print and repay money. Or is it a case of the government forcing public sector banks to invest a greater amount of their deposits than is required as per the law of the land, in government bonds?
Whatever be the case this excess lending to the government has led to a situation where banks are unable to cut interest rates.
It has also helped the government, allowing it to easily raise money from banks to finance its massive fiscal deficit at lower rates of interest. The fiscal deficit targeted for this financial year (i.e. the period between April 1, 2012 and March 31, 2013) was Rs 5,13, 590 crore. For the period April to November the fiscal deficit stood at around Rs 4,13,000 crore. This means that during the first eight months of the year, the fiscal deficit crossed 80% of the budgeted estimate.
If we project the fiscal deficit number for the first eight months for the entire financial year it is likely to come to Rs 6,16,000 crore, which is Rs 1,00,000 crore more than the budgeted fiscal deficit. And if the banks continue to help the government as they have in this financial year, the government can keep running its huge fiscal deficit rather easily.
There had been great pressure on the RBI governor D Subbarao to cut the repo rate. He had resisted the idea for a while now despite repeated hints given by the government in general and the finance minister P Chidambaram in particular. Now that he has gone ahead and cut the repo rate, it is not translating into subsequent cut in interest rates by banks.
In an interview to The Economic Times former RBI governor YV Reddy explained the friction between a central bank and the government by saying “A central bank that is always in agreement with the government is superfluous, just as a central bank that is always in disagreement is obnoxious. The solution really is to have messy coordination.”
To conclude, there is not much that the RBI can do to bring down interest rates. That will only happen once the government is able to control its fiscal deficit. And that is not happening any time soon. So higher EMIs and interest rates are here to stay.

The article originally appeared on on January 31, 2013.
(Vivek Kaul is a writer. He can be reached at [email protected])