A Primer on Bank Interest Rates for Real Estate Companies, Lawyers, Judges, Government and Everyone Else

The Supreme Court is currently hearing the loan moratorium case. Arguments have been made from different sides, on whether banks should charge an interest on loans during the moratorium and if an interest should be then charged on that interest.

I wanted to discuss a few arguments being offered by lawyers who are representing borrowers of different kinds in the Supreme Court. Either their understanding of interest rates is weak, or even if they do understand, they are just ignoring that understanding in order to make a powerful argument before the Supreme Court.

Let’s look at the issue pointwise. Also, this piece is for anyone who really wants to understand how interest rates really work. Alternatively, I could have headlined this piece, Everything You Ever Wanted to Know About Interest Rates But were Afraid to Ask.

1) Appearing for the real estate sector, Senior Advocate C A Sundaram told a bench of Justices Ashok Bhushan, R S Reddy and M R Shah: “Even if the interest is not waived, then it must be reduced to the rate at which banks are paying interest on deposits.”

What does this mean? Let’s say a real estate company has taken a loan of Rs 100 crore from a bank. On this it pays an interest of 10% per year. For the period of the moratorium the company doesn’t pay the interest on the loan. At the end of six months, the interest outstanding on the loan is Rs 5 crore (10% of Rs 100 crore for a period of six months). In the normal scheme of things this outstanding interest needs to be added to Rs 100 crore and the loan the builder now needs to repay Rs 105 crore. Of course, in the process of repaying this loan amount, the company will end up paying an interest on interest. If it wants to avoid doing that it simply needs to pay the outstanding interest of Rs 5 crore once the moratorium ends and continue repaying the original loan.

What Advocate Sundaram told the Supreme Court is that even if the interest on the loan during the moratorium is not waived, the interest rate charged on it should be lower and should be equal to the interest rate that banks are paying on their deposits.

The question of not charging an interest rate on loans during moratorium is totally out of question. Banks raise deposits by paying a rate of interest on it. It is these deposits they give out as loans. If they don’t charge an interest on their loans, how will they pay interest on their deposits?

Bank deposits remain the most popular form of saving for individuals. Imagine the social and financial disruption something like this would create.

Even the point about banks charging an interest rate during the moratorium which is equal to the interest rate they are paying on their deposits, is problematic. Other than paying an interest rate on deposits, banks have all kinds of other expenditures. They need to pay salaries to employees and off-role staff, rents for the offices and branches they operate out of, bear the cost of insuring deposits and also take into account, the loan defaults that are happening.

If the banks charge an interest rate on loans equal to the interest rate they pay on deposits, how are they supposed to pay for all the costs highlighted above?

2) More than this, I think there is a bigger problem with Senior Advocate Sundaram’s argument. Allow me to explain. Interest on money is basically the price of money. When a bank pays an interest to a deposit holder, he is basically compensating the deposit holder for not spending the money immediately and saving it. This saving is then lent out to anyone who needs the money. This is how the financial intermediation business works.

If real estate companies could today ask the courts to decide on the bank’s price of money, the banks could do something similar tomorrow. They could approach the courts with the argument that real estate companies need to reduce home prices, in the effort to sell more units, so that they are able to repay all the money they have borrowed from banks.

If courts can decide on how banks should carry out their pricing, they can also decide on how real estate companies should carry out their pricing. This is something that needs to be kept in mind.

3) This is a slightly different point, which might seem to have nothing to do with interest rates, but it does. The real estate industry is in dire straits and hence, wants the government, Reserve Bank of India (RBI) and the Supreme Court, to help. (I am going beyond what Advocate Sundaram told the Court).

In fact, banks and non-banking finance companies, have already been allowed to restructure builder loans. Former RBI governor Urjit Patel refers to the commercial real-estate-sector as the living dead borrowers in his book Overdraft.

The real estate sector had a great time between 2002 and 2013, for more than a decade, when they really raked in the moolah.

While they did this, they obviously kept the after-tax profits with themselves and they didn’t share it with anyone else. So, why should they be supported now? Why should their losses be socialised? And if losses of real estate sector are socialised, where does the system stop? This is a question well worth asking.

If these losses are socialised, the banks will try making up for it through other ways. This would mean lower interest rates on deposits than would otherwise have been the case. This would also mean higher interest rates on loans than would otherwise have been the case. There is no free lunch in economics.

4) Senior Advocate Rajiv Datta said that banks should not take the moratorium as a default period to charge interest on interest to individual borrowers, including those repaying home loans. As he said: “Profiteering at the cost of individual borrowers during a pandemic is like Shylock seeking his pound of flesh. Individual borrowers were not defaulting.”

While I have no love-lost for bankers, but generations of bankers have had to suffer thanks to the way the William Shakespeare portrayed a Jewish money lender in his play The Merchant of Venice.

The question is why is everyone so concerned only about the borrowers. What about the savers? The average fixed deposit rate is now down to 6%. This, when the rate of inflation is close to 7%. The savers are already losing out. Why should they lose more?

5) Another argument was put forward by Senior Advocate Sanjay Hegde, where he said that banks never passed the benefit of lower repo rate to consumers in the whole of 2019 to garner bigger profits. “When there is a pandemic, they should not think of profiteering and pass on the benefits granted by the RBI to borrowers by lowering the interest rate on loans,” he said.

This is a fundamental mistake that many people make where they assume a one to one relationship between the repo rate and loan interest rates. Repo rate is the interest rate at which the RBI lends money to banks. The idea in the heads of people and often portrayed in the media is that the repo rate is coming down and so, should loan interest rates, at the same pace.

In December 2018, the repo rate was at 6.5%. Since then it has been reduced to 4%. There has been a cut of 250 basis points. One basis point is one hundredth of a percentage. During the same period, the weighted average lending rate on outstanding loans has fallen from 10.35% to 9.71%, a fall of a mere 64 basis points.

So is Senior Advocate Hegde right in the argument he is making? Not at all. As I said earlier, the link between the repo rate and the lending rate is not one to one. The reason for that is very simple. Banks raise deposits and lend that money out as loans. For lending interest rates to fall, the deposit interest rates need to fall.

The weighted average deposit interest rates since December 2018 have fallen from 6.87% to 5.96% or a fall of 91 basis points. We see that even the deposit interest rates do not share a one to one relationship with the repo rate.

Why is that the case? If a depositor invested in a deposit at 8% interest three years back, he continues to be paid that 8% interest, even when the repo rate is falling. Further, even though banks reduce the interest rate they pay on new fixed deposits, they cannot do so on the older fixed deposits. The fixed deposit interest rates are fixed and that is why they are called fixed deposits.

If the repo rate and the fixed deposit interest rates need to have a one to one relationship, meaning a 25 basis points cut in the repo rate leads to a 25 basis points cut in deposit rates, which translates into a 25 basis points cut into lending rates, then banks need to offer variable interest rate deposits and not fixed deposits. Again, that is a recipe for a social disruption.

If we look at fresh loans given by banks, the interest charged on them has fallen from 9.79% in December 2018 to around 8.52%, a fall of 127 basis points, which is much higher than the overall fall of just 64 basis points. This is primarily because the interest rate on fresh fixed deposits has fallen faster than the interest rates on fixed deposits as a whole.

This still leaves the question why has the overall lending rate fallen by 64 basis points when the overall deposit rate has fallen by 91 basis points. One reason lies in the fact that banks have a massive amount of bad loans and they are just trying to increase the spread between the interest they charge on their loans and the interest that they pay on their deposits, by not cutting the lending rate as fast as the deposit rate.

This will mean a higher profit, which can compensate for bad loans to some extent. Over and above this, there is some profiteering as well. But the situation is nowhere as bad as the lawyers are making out to be.

The reason for that is simple. There is a lot of competition in banking and if a particular bank tries to earn excessive profits, a competitor can easily challenge those profits by charging a slightly lower rate of interest and getting some of the business.

To conclude, allowing banks to set their own interest rates is at the heart of a successful banking business. And no one should be allowed to mess around with that. Also, for the umpteenth time, interest rates are not just about the repo rate.

It’s Not the Interest Rate, Stupid


This week there has been an overdose on Raghuram Rajan, the governor of the Reserve Bank of India(RBI) and his decision to not take on a second term. I guess some readers haven’t liked that. Nonetheless, it is important to discuss his ideas and thoughts, given that this is an opportunity to explain some basic economics, which many people don’t seem to understand.

I don’t blame them given the surfeit of reading material that is generated these days. I get many WhatsApp forwards with spectacularly illogical conclusions and many people seem to believe in them. One of the theories going around these days is that Rajan did not cut interest rates fast enough, and this impacted both businesses as well as consumers.

I have tried to counter this argument over the last one week in different ways. But given that I have limited access to data, some questions still remained unanswered. Governor Rajan though does not have these limitations. In his latest speech, made in Bangalore, yesterday, he explained in his usual simple style, as to why interest rates weren’t slowing down bank lending.

But before we get down to that, I would like to discuss something else.

In one of the many columns written to justify Rajan’s decision of not taking on a second term, BJP member and newspaper editor Chandan Mitra, wrote: “Rajan’s emphasis on increasing savings fell on deaf ears because the middle class was by now impatient to spend, not save.”

The insinuation here is that if Rajan had cut interest rates fast enough, the middle class would have borrowed and spent. This would have reinvigorated the Indian economy. But then the Indian economy grew by 7.6% in 2015-2016. It is fastest growing major economy in the world. So, I really don’t what Mitra was cribbing about. Also, Rajan has cut the repo rate by 150 basis points since January 2015.

Rajan in his speech made it clear through data that interest rates hadn’t held back bank lending. As he said:“The slowdown in credit growth has been largely because of stress in the public sector banking and not because of high interest rate.” Take a look at the following chart.

Chart 1 : Non food credit growthChart1 Non Food credit growth 

The yellow line shows the overall lending growth of the new generation private sector banks (Axis, HDFC, ICICI, and IndusInd) over the last two years. What this shows very clearly is that the lending growth of new generationprivate sectors banks has had an upward trend with a few small blips in between.

In contrast the lending growth of public sector banks (the blue line) has slowed down considerably over the last two years. Let’s look at the bank lending growth in a little more detail. The following chart shows the bank lending growth to industry over the last two years.

Chart 2 : Credit to industryChart 2 Credit to Industry 

As can be seen from the above chart, the lending to industry, carried out by the new generation private sector banks has been robust. In fact, in the last one year, it has grown by close to 20%. Hence, the new generation private sector banks have been lending to industry at a very steady pace.

When it comes to public sector banks, the same cannot be said. The lending growth has been falling over the last two years. Now it is in negative territory. In fact, due to this, the overall lending by banks to industry in the last one year was at just 0.1%. The figure was at 5.9% between April 2014 and April 2015. A similar trend can be seen from the following chart when it comes to lending to micro and small enterprises.

Chart 3 : Credit to Micro and Small EnterpriseChart 3 Credit to Micro & Small Enterprices 

This has led many people to believe that high interest rates have slowed down bank lending. As Rajan put it:“The immediate conclusion one should draw is that this is something affecting credit supply from the public sector banks specifically, perhaps it is the lack of bank capital.”

But as I have mentioned in the past, both public sector banks as well as private banks, have been happy to lend to the retail sector or what RBI calls personal loans.

These include home loans, vehicle loans, credit card outstanding, consumer durable loans, loans against shares, bonds and fixed deposits, and what we call personal loans. As I have mentioned in the past, retail loans have grown at a pretty good rate in the last one year.

The retail loans of banks have grown by 19.7% in the last one year. Between April 2014 and April 2015(between April 18, 2014 and April 17, 2015), these loans had grown by 15.7%. Hence, the retail loan growth has clearly picked up over the last one year. What is interesting is that in the last one-year retail loans have formed around 45.6% of the total loans given by banks (i.e. non-food credit). Interestingly, between April 2014 and April 2015, retail loans had formed 32.4% of the total lending.

This is precisely the point that Rajan made in his speech. Take a look at the following chart:

Chart 5 : Personal LoansChart 5 Personal Loans 

In this graph, the retail ending growth of public sector banks and new generation private sector banks has been plotted. As can be seen, the two curves are almost about to meet. What this tells us is that when it comes to lending to the retail sector, the public sector lending growth is almost as fast as the new generation private sector bank. And given that the public sector banks are lending on a bigger base, they are carrying out a greater amount of absolute lending.

As Rajan put it in his speech: “If we look at personal loan growth (Chart 5), and specifically housing loans (Chart 6), public sector bank loan growth approaches private sector bank growth. The lack of capital therefore cannot be the culprit. Rather than an across-the-board shrinkage of public sector lending, there seems to be a shrinkage in certain areas of high credit exposure, specifically in loans to industry and to small enterprises. The more appropriate conclusion then is that public sector banks were shrinking exposure to infrastructure and industry risk right from early 2014 because of mounting distress on their past loan.”

This isn’t surprising given that banks are carrying a huge amount of bad loans on lending to industry. As the old Hindi proverb goes: “Doodh ka jala chaach bhi phook-phook kar peeta hai – Once bitten twice shy.”

As I have mentioned in the past, in case of the State Bank of India, the gross non-performing ratio (or the bad loans ratio) of retail loans for 2015-2016 was at 0.75% of the total loans given to the retail sector. This came down from 0.93% in 2014-2015.

The bad loans ratio of large corporates has jumped from 0.54% to 6.27%. The bad loans ratio of mid-level corporates has jumped from 9.76% to 17.12%. And the bad loan ratio of small and medium enterprises has remained more or less stable and increased marginally from 7.78% to 7.82%. This is a trend seen across public sector banks. Hence, it isn’t surprising that public sector banks do not want to lend to the industry, at this point of time.

Take a look at the following chart, which plots the home loan lending growth of public sector banks and new generation private sector banks.

Chart 6 : Housing LoansChart 6 Housing Loans 

In this case, the lending growth of public sector banks is as fast as the lending growth of new generation private sector banks.

What all this tells us very clearly is that when it comes to the retail segment, public sector banks are lending as much as they can. This refutes Mitra’s point where he said that the middle class isn’t borrowing and spending because of high interest rates. If middle class wasn’t borrowing and spending, retail lending wouldn’t have grown by close to 20%, in the last one year.

In fact, credit card outstanding of banks has grown by 31.2% in the last one year, after growing by 22.9% between April 2014 and April 2015. So, I have really no clue as to what is Mitra talking about. Vehicle loans have grown by 19.7% against 15.4% earlier. Guess, it’s time he opened a few excel sheets before just mindlessly commenting on things.

Rajan summarised it the best when he said: “These charts refute another argument made by those who do not look at the evidence – that stress in the corporate world is because of high interest rates. Interest rates set by private banks are usually equal or higher than rates set by public sector banks. Yet their credit growth does not seem to have suffered. The logical conclusion therefore must be that it is not the level of interest rates that is the problem. Instead, stress is because of the loans already on public sector banks balance sheets, and their unwillingness to lend more to those sectors to which they have high exposure.”

To conclude, and with due apologies to Bill Clinton, “It’s not the interest rate, stupid!”

The column originally appeared on the Vivek Kaul’s Diary on June 23, 2016

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 www.firstpost.com on July 5, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)

Why falling car sales is bad news for almost everybody

Vivek Kaul
The great film director Alfred Hitchcock started making films in the early 1920s in Great Britain. This was the era of silent movies. But Hitchcock really came into his own once he moved to Hollywood, where he first made the very dark Rebecca in 1940. For the next twenty years Hitchcock was at his peak churning out one hit film after another. This lasted till he made his scariest movie Psycho in 1960.
Among the many classics that he made during the period was a movie called 
Rear Window (which Ashutosh Gowariker before he became a director of epic movies tried to copy as Pehla Nasha). The movie tells a story of a photographer Jeff who has broken his leg and is bed ridden. A nurse called Thelma is taking care of him.
Jeff and Thelma are shown to be having conversations throughout the movie. One such conversation is reproduced below.
Stella: You heard of that market crash in ’29? I predicted that.
Jeff: Oh, just how did you do that, Stella?
Stella: Oh, simple. I was nursing a director of General Motors. Kidney ailment, they said. Nerves, I said. And I asked myself, “What’s General Motors got to be nervous about?” Overproduction, I says; collapse. When General Motors has to go to the bathroom ten times a day, the whole country’s ready to let go.
In the conversation above Stella tells Jeff that she had predicted the stock market crash of 1929 which led to the Great Depression, once she figured out that General Motors was in trouble because they were not selling enough and as a result overproducing. 
While Stella’s claim of having predicted the stock market crash was a little far fetched, the conversation in a very simple way shows the clear link that exists between the automobile industry of a country and its overall economy. General Motors got into trouble only when the American economy was in trouble and this in turn added to the troubles of the American economy further. So when car sales are down dramatically it is a reflection of the overall economy being in a bad shape and the stiuation probably worsening in the days to come. 
The domestic passenger car sales in India hit a twelve year low for the month of February 2013 when they fell by 25.71% to 1,58,513 units in comparison to the same month last year. In February 2012, domestic passenger car sales were at 2,13,362 units. This is the biggest decline in domestic passenger car sales since December 2000, when sales had declined by 39.9%.
In fact for the period between April 2012 and February 2013, car sales were down by 4.6%. This is a reflection of the overall state of the Indian economy, which is slowing down considerably. 
Lets look at the points one by one. Household savings have gone down from 25.2% of the GDP in 2009-2010(the period between April 1, 2009 and March 31, 2010) to 22.3% of the GDP in 2011-2012(the period between April 1, 2011 and March 31, 2012). While the household savings number for the current year is not available, the broader trend in savings has been downward. 
So people have been saving lesser over the last few years. A straightforward explanation for this is the high inflation that has prevailed over the last few years. The consumer price inflation for the month of February 2013 stood at 10.91% in comparison to 10.79% for the month of January 2013. Food prices in February 2013 rose at a much faster 13.73%.
People are possibly spending greater proportions of their income to meet the rising expenses due to high inflation and this has in turn led to a lower savings rate. High inflation would not have been a problem if incomes also had been growing at a fast rate. But that doesn’t seem to be the case.
Estimates released by the Ministry of Statistics and Programme Implementation clearly point that out. As a release dated February 7,2013, states “The per capita income in real terms (at 2004-05 prices) during 2012-13 is likely to attain a level of Rs.39,143 as compared to the First Revised Estimate for the year 2011-12 of Rs. 38,037. The growth rate in per capita income is estimated at 2.9 per cent during 2012-13, as against the previous year’s estimate of 4.7 per cent.”
So prices have been growing at a very fast rate and incomes haven’t. In this scenario people have been cutting down on the consumption of high costs items like cars as they struggle to save the same amount of money as they had been doing in the past.
High inflation and lower household savings has also led to higher interest rates, which in turn has meant higher EMIs on automobile loans. This also has had its impact on car sales. And high inflation is here to stay. As Ruchir Sharma, a Managing Director & Head of Emerging Markets and Global Macro, Morgan Stanley Investment Managemen, recently said “The whole issue is that inflation is symptomatic of a wider problem in India.”
What has not helped is the fact that the government borrowing to finance its increased fiscal deficit(the difference between what it earns and what it spends) has also gone up over the last few years. Banks have had a lower pool of money to borrow from because of this and have had to offer higher interest rates to attract depositors. Higher interest rates on deposits have meant higher interest rates on loans and thus higher EMIs. 
But the greater impact has been because of the government deciding to allow the price of petrol and diesel to go up. With the government holding back the price of petrol and diesel for a very long time, prospective car buyers kept buying cars because they were not feeling the pinch of the high cost of fuel. Now any prospective car buyer also needs to take the high cost of fuel into account while making a decision. Since people were not paying the right price for diesel and petrol, this had artificially held up the demand for cars. Now that demand is coming down crashing. The point is that any artificial demand cannot hold up beyond a point. 
What this also tells us is that if the government had allowed the market to operate when it came to fuel prices, auto demand would have not come crashing down as it has, but would have adjusted gradually to a change in higher fuel prices. And you don’t need to be an expert to understand that a gradual adjustment is better than a dramatic fall. 
Now this is just one part of the story which explains why car sales have slowed down dramatically. But there is another part to the story. Slowing car sales also slow down other sectors of the economy as well, and this slows down the overall economy further. As T N Ninan wrote in a brilliant column in Business Standard in January 2013 “The car industry is a key economic marker, because of its unmatched backward linkages – to component manufacturers, tyre companies, steel producers, battery makers, glass manufacturers, paint companies, and so on – and forward linkages to energy demand, sales and servicing outlets, et al.”
In that context the fall of car sales by more than 25% in the month of February 2013 should be a clear sign of worry. Slowing car sales are also a reflection of the fact that people expect the bad times to either continue or to get even worse in the months to come. And this makes them hold onto the money they would have used to buy a car otherwise. It also means that they do not want to commit to an EMI right now. 
Floyd Norris writing in The New York Times explains it best: “New-car sales can be a particularly sensitive economic indicator because few people really need to buy a new car, and thus tend not to do so when they feel uncertain about their economic prospects. Even if a car purchase can no longer be delayed, a used car is an alternative.”
The article originally appeared on www.firstpost.com on March 12, 2013 

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

Of 9% economic growth and Manmohan’s pipedreams

Vivek Kaul

Shashi Tharoor before he decided to become a politician was an excellent writer of fiction. It is rather sad that he hasn’t written any fiction since he became a politician. A few lines that he wrote in his book Riot: A Love Story I particularly like. “There is not a thing as the wrong place, or the wrong time. We are where we are at the only time we have. Perhaps it’s where we’re meant to be,” wrote Tharoor.
India’s slowing economic growth is a good case in point of Tharoor’s logic. It is where it is, despite what the politicians who run this country have to say, because that’s where it is meant to be.
The Prime Minister Manmohan Singh in his independence-day speech laid the blame for the slowing economic growth in India on account of problems with the global economy as well as bad monsoons within the country. As he said “You are aware that these days the global economy is passing through a difficult phase. The pace of economic growth has come down in all countries of the world. Our country has also been affected by these adverse external conditions. Also, there have been domestic developments which are hindering our economic growth. Last year our GDP grew by 6.5 percent. This year we hope to do a little better…While doing this, we must also control inflation. This would pose some difficulty because of a bad monsoon this year.
So basically what Manmohan Singh was saying that I know the economic growth is slowing down, but don’t blame me or my government for it. Singh like most politicians when trying to explain their bad performance has resorted to what psychologists calls the fundamental attribution bias.
As Vivek Dehejia an economics professor at Carleton University in Ottawa, Canada, told me in a recent interview I did for the Daily News and Analysis (DNA) Fundamentally attribution bias says that we are more likely to attribute to the other person a subjective basis for their behaviour and tend to neglect the situational factors. Looking at our own actions we look more at the situational factors and less at the idiosyncratic individual subjective factors.”
In simple English what this means is that when we are analyzing the performance of others we tend to look at the mistakes that they made rather than the situational factors. On the flip side when we are trying to explain our bad performance we tend to blame the situational factors more than the mistakes that we might have made.
So in Singh’s case he has blamed the global economy and the deficient monsoon for the slowing economic growth. He also blamed his coalition partners. “As far as creating an environment within the country for rapid economic growth is concerned, I believe that we are not being able to achieve this because of a lack of political consensus on many issues,” Singh said.
Each of these reasons highlighted by Singh is a genuine reason but these are not the only reasons because of which economic growth of India is slowing down. A major reason for the slowing down of economic growth is the high interest rates and high inflation that prevails. With interest rates being high it doesn’t make sense for businesses to borrow and expand. It also doesn’t make sense for you and me to take loans and buy homes, cars, motorcycles and other consumer durables.
The question that arises here is that why are banks charging high interest rates on their loans? The primary reason is that they are paying high interest rate on their deposits.
And why are they paying a high interest rate on their deposits? The answer lies in the fact that banks have been giving out more loans than raising deposits. Between December 30, 2011 and July 27, 2012, a period of nearly seven months, banks have given loans worth Rs 4,16,050 crore. During the same period the banks were able to raise deposits worth Rs 3,24,080 crore. This means an incremental credit deposit ratio of a whopping 128.4% i.e. for every Rs 100 raised as deposits, the banks have given out loans of Rs 128.4.
Thus banks have not been able to raise as much deposits as they are giving out loans. The loans are thus being financed out of deposits raised in the past. What this also means is that there is a scarcity of money that can be raised as deposits and hence banks have had to offer higher interest rates than normal to raise this money.
So the question that crops up next is that why there is a scarcity of money that can be raised as deposits? This as I have said more than few times in the past is because the expenditure of the government is much more than its earnings.
The fiscal deficit of the government or the difference between what it earns and what it spends has been going up, over the last few years. For the financial year 2007-2008 the fiscal deficit stood at Rs 1,26,912 crore. It went up to Rs 5,21,980 crore for financial year 2011-2012. In a time frame of five years the fiscal deficit has shot up by nearly 312%. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore.
This difference is made up for by borrowing. When the borrowing needs of the government go through the roof it obviously leaves very little on the table for the banks and other private institutions to borrow, which in turn means that they have to offer higher interest rates to raise deposits. Once they offer higher interest rates on deposits, they have to charge higher interest rate on loans.
A higher interest rate scenario slows down economic growth as companies borrow less to expand their businesses and individuals also cut down on their loan financed purchases. This impacts businesses and thus slows down economic growth.
The huge increase in fiscal deficit has primarily happened because of the subsidy on food, fertilizer and petroleum. One of the programmes that benefits from the government subsidy is Mahatma Gandhi National Rural Employment Guarantee Act (MGNREGA). The scheme guarantees 100 days of work to adults in any rural household. While this is a great short term fix it really is not a long term solution. If creating economic growth was as simple as giving away money to people and asking them to dig holes, every country in the world would have practiced it by now.
As Raghuram Rajan, who is taking over as the next Chief Economic Advisor of the government of India, told me in an interview I did for DNA a couple of years back “The National Rural Employment Guarantee Scheme (NREGS, another name for MGNREGA), if appropriately done it is a short term insurance fix and reduces some of the pressure on the system, which is not a bad thing. But if it comes in the way of the creation of long term capabilities, and if we think NREGS is the answer to the problem of rural stagnation, we have a problem. It’s a short term necessity in some areas. But the longer term fix has to be to open up the rural areas, connect them, education, capacity building, that is the key.
But the Manmohan Singh led United Progressive Alliance seems to be looking at the employment guarantee scheme as a long term solution rather than a short term fix. This has led to burgeoning wage inflation over the last few years in rural areas.
As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic MiraclesThe wages guaranteed by MGNREGA pushed rural wage inflation up to 15 percent in 2011”.
Also as more money in the hands of rural India chases the same number of goods it has led to increased price inflation as well. Consumer price inflation currently remains over 10%. The most recent wholesale price index inflation number fell to 6.87% for the month of July 2012, from 7.25% in June. But this experts believe is a short term phenomenon and inflation is expected to go up again in the months to come.
As Ruchir Sharma wrote in a column that appeared yesterday in The Times of IndiaFor decades India’s place in the rankings of nations by inflation rates also held steady, somewhere between 78 and 98 out of 180. But over the past couple of years India’s inflation rate is so out of whack that its ranking has fallen to 151. No nation has ever managed to sustain rapid growth for several decades in the face of high inflation. It is no coincidence that India is increasingly an outlier on the fiscal front as well with the combined central and state government deficits now running four times higher than the emerging market average of 2%.” (You can read the complete column here).
So to get economic growth back on track India has to control inflation. The Reserve Bank of India (RBI) has been trying to control inflation by keeping the repo rate, or the rate at which it lends to banks, at a high level. One school of thought is that once the RBI starts cutting the repo rate, interest rates will fall and economic growth will bounce back.
That is specious argument at best. Interest rates are not high because RBI has been keeping the repo rate high. The repo rate at best acts as an indicator. Even if the RBI were to cut the repo rate the question is will it translate into interest rate on loans being cut by banks? I don’t see that happening unless the government clamps down on its borrowing. And that will only happen if it’s able to control the subsidies.
The fiscal deficit for the current financial year 2012-2013 has been estimated at Rs Rs Rs 5,13,590 crore. I wouldn’t be surprised if the number even touches Rs 600,000 crore. The oil subsidy for the year was set at Rs 43,580 crore. This has already been exhausted. Oil prices are on their way up and brent crude as I write this is around $115 per barrel. The government continues to force the oil marketing companies to sell diesel, LPG and kerosene at a loss. The diesel subsidy is likely to continue given that with the bad monsoon farmers are now likely to use diesel generators to pump water to irrigate their fields. With food inflation remaining high the food subsidy is also likely to go up.
The heart of India’s problem is the huge fiscal deficit of the government and its inability to control it. As Sharma points out in Breakout NationsIt was easy enough for India to increase spending in the midst of a global boom, but the spending has continued to rise in the post-crisis period…If the government continues down this path India, may meet the same fate as Brazil in the late 1970s, when excessive government spending set off hyperinflation and crowded out private investment, ending the country’s economic boom.”
These details Manmohan Singh couldn’t have mentioned in his speech. But he tried to project a positive picture by talking about the planning commission laying down measures to ensure a 9% rate of growth. The one measure that the government needs to start with is to cut down the fiscal deficit. And the probability of that happening is as much as my writing having more readers than that of Chetan Bhagat. Hence India’s economic growth is at a level where it is meant to be irrespective for all the explanations that Manmohan Singh gave us and the hope he tried to project in his independence-day speech.
But then you can’t stop people from dreaming in broad daylight. Even Manmohan Singh! As the great Mirza Ghalib who had a couplet for almost every situation in life once said “hui muddat ke ghalib mar gaya par yaad aata hai wo har ek baat par kehna ke yun hota to kya hota?
(The article originally appeared on www.firstpost.com on August 16,2012. http://www.firstpost.com/economy/of-9-economic-growth-and-manmohans-pipedreams-419371.html)
Vivek Kaul is a writer and can be reached at [email protected]