Over the last one year, bank interest rates have fallen majorly, at least in theory (it will become clear later in the column, why I say this). The question is, who is benefitting from the lower interest rates? The savers, whose fixed deposits have matured, have had to reinvest them at significantly lower interest rates. This includes retirees who have seen interest rates on their deposits, fall from nine per cent to six per cent in a short period of time. In the process, their incomes have crashed by a third. Not surprisingly, they are having a tough time.
People have suggested that senior citizens should invest with the post office where higher interest rates are on offer. Anyone who has actually invested money with the post office for generating a regular income, would never suggest anything like this. Their service levels are abysmally low. They can give a thorough run around to anyone looking to get paid regularly on the investment he has made with the post office.
In fact, I know of several retirees who have reluctantly moved their investments into mutual funds (both equity and debt), given the low after-tax returns on fixed deposits. Even if the returns on mutual funds are the same as bank fixed deposits, the different tax treatment for both these forms of investing, helps generate higher after-tax returns in case of mutual funds.
This investing strategy has worked well for retirees in the last one year, given that the stock market has rallied massively. Nevertheless, is this a sustainable strategy in the long-term for anyone who is looking to generate a regular income out of his accumulated corpus, given the volatility that comes with investing in a mutual fund?
In a country with almost no social security and a health care system which keeps getting expensive by the day, this is a fair question to ask.
Another set of savers who has lost out due to low interest rates are people saving for their future, the wedding and education of their kids, and their own retirement. These people now need to save more in order to meet their long-term investment goals. Of course, these people still have the option of discovering the power of compounding by investing in mutual funds through the systematic investment plan (SIP) route.
But given the abysmal levels of financial literacy that prevail in the country, the chances that they will be mis-sold a unit linked insurance plan(ULIP) by a private insurance company or an endowment or a money-back policy by Life Insurance Corporation of India, remain very high. These forms of investing remain the worst way you can invest your money.
Also, consumption growth and interest rates are closely linked. Conventional economic logic tells us that at lower interest rates people borrow and spend more, and this increases private consumption growth and in turn helps economic growth. QED.
While that may be true for developed countries, it doesn’t quite work like that in India. In India, if interest rates fall, the retirees need to cut down on their regular expenditure because their regular income also falls. People who are saving for the long-term also need to save more in order to meet their investment goals.
Given that most household financial savings get invested in fixed deposits, a fall in interest rates makes people feel less wealthy and this has an impact on their consumption. Due to these reasons people end up cutting down on their expenditure. This is reflected to some extent in Figure 1, which plots the growth in private consumption expenditure over the last few years.
As interest rates have fallen through 2017, the growth in private consumption expenditure has collapsed from 11.1 per cent to 6.5 per cent. As of December 2016, private consumption expenditure formed 59 per cent of the Indian gross domestic product. Since then, it has fallen to 54 per cent. So, much for lower interest rates.
There are two sides to interest rates, the saving side which I was talking about up until now, and the borrowing side, which I will talk about in the remaining part of this column.
The total non-food lending carried out by Indian banks has actually contracted during this financial year. But weren’t lower interest rates supposed to help increase lending? Now only if economic theory and reality played out same to same, the world would be such a different place.
Banks are extremely quick to cut interest rates on their fixed deposits, as well as raising interest rates on their loans. Nevertheless, the same cannot be said about a situation where they need to pass on the benefit of lower interest rates to their borrowers.
Let’s take the example of people who have taken on home loans from banks as well as housing finance companies. Over the last one year, the interest rate on a home loan has fallen from 80 to 100 basis points. One basis point is one-hundredth of a percentage.
The trouble is in many cases the banks and the housing finance companies haven’t bothered to inform the borrower, about the lower interest rate. And the borrower has unknowingly continued to pay the higher EMI. This never happens when the banks and the housing finance companies need to raise interest rates on their home loans. In that case, the letter/sms/email arrives right on time.
In fact, I have heard cases where people have pointed this dichotomy out to a leading housing finance company, and they have been told that they are expected to come to the office of the housing finance company and keep checking. So much for market competition which is supposed to lower interest rates. Of course, the stock market rewards such companies with a higher price to earnings ratio, given that they can do these things, get away with it, and make more money in the process.
The media which is quick to announce lower EMIs whenever RBI cuts the repo rate, never goes back to check whether EMIs have actually fallen. This is simply because it is easier to take the theoretical way out and announce lower EMIs when RBI cuts the repo rate, whereas actual checking would involve doing some legwork and speaking to banks, housing finance companies and borrowers. And who wants to work hard? It’s worth pointing out here that banks are huge advertisers in the media.
The question is when higher interest rates are passed on immediately, why is the same not true with lower home loan interest rates? What are the Reserve Bank of India (RBI) and the National Housing Bank (the RBI subsidiary which regulates housing finance companies) doing about this? Aren’t the regulators also supposed to take care of the consumers? Or are they just there to bat for those who they regulate? Or is it a case of “regulatory capture” where those who are regulated (i.e. the banks and the housing finance companies) given that they are organised, manage to get their point of view to the regulator, but the borrowers, given that they are not organised, cannot do that.
Whatever it is, it is not fair. And the RBI and the National Housing Bank need to do something about it. Consumer protection is something that should be high on their agenda, even though it may be the most unglamorous of things that they are supposed to do.
On August 30, 2017, the Reserve Bank of India(RBI) published its annual report. The annual report had data points looking at which we can finally say that demonetisation has not met any of the objectives that it set out to achieve.
On November 8, 2016, the prime minister Narendra Modi in an address to the nation said that the notes of denomination Rs 500 and Rs 1,000, would not be legal tender from November 9, 2016, onwards. People in possession of these notes could deposit them in banks until December 30, 2016. In value terms notes worth Rs 15.44 lakh crore were demonetised.
As per the press release accompanying the decision to demonetise, there were two aims of demonetisation: 1) Eliminating Black Money which casts a long shadow of parallel economy on our real economy. 2) Eliminating Fake Indian Currency Notes (FICN).
Let’s look at how successful demonetisation has been in achieving these two main goals. The idea was that people who had black money in the form of Rs 500 and Rs 1,000, would not deposit it in the banks for the fear of being identified by the government and in the process black money would be destroyed.
This was a point that was made over and over again by those in favour of demonetisation. As finance minister Arun Jaitley said in an interview: “Obviously people who have used cash for crime purposes are not foolhardy enough to try and risk and bring the cash back into the system because there will be questions asked.”
Niti Aayog Member Bibek Debroy was specific on the proportion of demonetised money that would not come back. As he said in an interview: “Even now, Rs 1.6 lakh crore is what will be missing at the end of it all. Those are the figures. If I take a base of roughly rounding off demonetised currency around Rs 16 lakh crore, 10 per cent of it is about Rs 1.6 lakh crore.” Hence, Debroy felt that currency worth Rs 1.6 lakh crore would not come back and this would lead to the destruction of black money.
The American-Indian economist Jagdish Bhagwati (along with two co-authors) was even more optimistic on this front, and in a column in the Mint newspaper on December 27, 2016, wrote: “Suppose we accept the estimate that one-third of the approximately Rs 15 trillion [Rs 15 lakh crore] in demonetised notes is black money.” These economists did not bother to explain, what logic did they base their assumption on.
The RBI Annual Report on Page 195 says that demonetised notes worth Rs 15.28 lakh crore were deposited into banks, up to June 30, 2017. This basically means that almost 99 per cent of the demonetised money was deposited into banks. Hence, almost all the black money held in the form of cash, also made it back into the banks and wasn’t really destroyed, as had been hoped.
Given this, instead of destroying black money held in the form of cash, demonetisation seems to have become a legal money laundering scheme, where people with black money have found ingenious ways to deposit it into the banking system. So, the first objective of demonetisation of eliminating black money has not been achieved.
Now we are being told that just because the money has been deposited into banks that does not mean it is not black money. And given this, the Income Tax department now has the data and will go after those people who have deposited their black money into banks. So far so good.
Let’s look at the past record of the Income Tax department when it comes to going after people having black money and achieving convictions. Take a look at Table 1.
Table 1: Year wise details of number of cases in which prosecutions were launched by the Income Tax Department.
No. of cases in which presecutions launched
No. of persons convicted
* Provisional figures upto 31st October, 2016
What does Table 1 tell us? It shows the extremely limited capacity of the Income Tax Department when it comes to bringing tax evaders to book. Even if the Income Tax department improves on these numbers, there isn’t much hope on the tax collection front. The prime minister Narendra Modi in his Independence Day speech said: “More than Rs 2 lakh crore black money has reached banks.” An impression is being created that this money is just waiting to find its way into government coffers. The people who have this black money aren’t exactly stupid. They aren’t waiting to hand it over to the government. They have access to good lawyers and chartered accountants and they know how the Indian system works.
Looking at this, it is safe to say the government is just trying to defend a bad decision and it is highly unlikely that it will earn a significant amount from all this black money.
In fact, the Pradhan Mantri Garib Kalyan Yojana, the income declaration scheme, launched by the government in the aftermath of demonetisation, failed miserably. The scheme which was launched on December 16, 2016, managed to collect all of Rs 2,300 crore as taxes. This tells us very clearly how much those who have black money fear the taxman in this country.
Now let’s jump to the second issue of eliminating fake currency notes. As far as detecting fake currency is concerned, nothing much seems to have happened on this front. Data from the RBI annual report tells us that the number of fake Rs 500 (old series) and Rs 1,000 notes detected between April 2016 to March 2017 was 5,73,891. The total number of demonetised notes stood at around 2,400 crore. This basically means that as a proportion the fake notes identified between April 2016 to March 2017 stands close to 0 per cent of the demonetised notes.
The total number of Rs 500 and Rs 1,000 fake notes detected between April 2015 and March 2016, stood at 4,04,794. And this happened without any demonetisation. Hence, demonetisation has failed on its two major objectives.
Now let’s look at the third objective of demonetisation. In the original scheme of things increasing cashless transactions wasn’t on the table at all. It came into the scheme of things once prime minister Modi talked about it in the Mann ki Baat programme on radio on November 27, 2016, where he said: “The great task that the country wants to accomplish today is the realisation of our dream of a ‘Cashless Society’. It is true that a hundred percent cashless society is not possible. But why should India not make a beginning in creating a ‘less-cash society’? Once we embark on our journey to create a ‘less-cash society’, the goal of ‘cashless society’ will not remain very far.”
How have we done on this front? Let’s take a look at Figure 1 and Figure 2. These figures plot the total number of cashless transactions through the years in terms of volume (i.e. number) and value of the transactions. I have ignored the Real Time Gross Settlement (RTGS) mode of transferring money because it can be used only for transactions of Rs 2 lakh and over. Hence, it clearly does not fall in the retail domain.
What does Figure 1 tell us? It tells us very clearly that the total number of cashless transactions rose in the aftermath of demonetisation. They have fallen since then and are now more or less back on the trend growth line (i.e. the red line in Figure 1). The trend growth line has been plotted in order to take care of the fact that cashless transactions had been growing anyway, irrespective of demonetisation.
In fact, between March 2017 when cashless transactions peaked and June 2017, the total number of cashless transactions have fallen by 10.1 per cent.
Now take a look at Figure 2.
Figure 2 clearly tells us that the total value of cashless transactions is now below the trend line. As former RBI governor said in a recent interview: “If you look at electronic transactions, you see that there was a blip-up when demonetisation happened but it has come back to broadly the trend growth line.”
One form of cashless payments which has seen good growth is the United Payment Interface. But it forms just 0.6 per cent of the overall cashless transactions and it will be a while before it forms a substantial portion.
Given this, the 2+1 original aims of demonetisation have flopped. The data clearly shows us that.
Of course, we are now being told of new benefits of demonetisation. Take the case of the number of returns being filed going up. Very true. But has it led to increased tax collections? A press release put out by the ministry of finance on August 9, 2017, states the following: “The Direct Tax collections up to July,2017[i.e. between April 2017 and July 2017] in the Current Financial Year 2017-18 continue to register steady growth. Direct Tax collection during the said period, net of refunds, stands at Rs. 1.90 lakh crore which is 19.1% higher than the net collections for the corresponding period of last year.”
Basically, direct tax collections have grown by 19.1 per cent during the first four months of this financial year in comparison to the same period in the last financial year. Hence, has demonetisation led to an increase in the growth of collection of direct taxes?
A press release put out by the ministry of finance on August 9, 2016, had this to say: “The figures for direct tax collections up to July, 2016 show that net revenue collections are at Rs.1.59 lakh crore which is 24.01% more than the net collections for the corresponding period last year.”
Hence, in the period between April to July 2016, the direct tax collections had grown by 24 per cent, without the demonetisation of currency which was carried out in November 2016. What this tells us is that direct tax collections grew faster before demonetisation than they are growing after demonetisation.
Personal income tax collections have grown by 15.7 per cent during the first four months of this financial year. They had grown by 46.6 per cent during the first four months of the previous financial year. So much for increase in taxes collected.
What this tells us is that demonetisation has slowed down the economy and given that the growth in direct taxes has slowed down as well.
Another point being made is that with all the money coming into the banking system, the interest rates have come down. Yes, they have. But has it led to increased lending, is a question no one is asking. Between the end of October 2016 and the end of July 2017, the total non-food lending carried out by banks stood at Rs 2,75,690 crore. The total non-food lending carried out by banks between end of October 2015 and the end of July 2016 had stood at Rs 3,43,013 crore. Hence, bank lending after demonetisation has fallen by close to 20 per cent, if we were to compare it to a similar period in the years gone by.
This is a point that I keep making. People and companies borrow when they are in a position to repay and not simply because interest rates are down. Demonetisation has had a negative impact on the ability of people to repay loans.
Another point that needs to be made here is that 62 per cent of household financial savings in India are invested in deposits. A fall in interest rates hurts people who invest in deposits. This includes senior citizens who use fixed deposits a generate a monthly income. It also includes people saving for the future for their wedding and education of their children. These people are many more in number than borrowers. With lower interest rates, they have to cut down on their current consumption expenditure. This hurts overall economic growth.
Demonetisation has also slowed down on overall economic growth. Take a look at Figure 3. It plots the GDP growth rate of India since March 2016.
As can be seen from Figure 3, the GDP growth rate between July and September 2016 had stood at 7.53 per cent. This was before demonetisation was announced in November 2016. It has since fallen to 5.72 per cent. This is clearly an impact of demonetisation. As Rajan said in an interview: “Let us not mince words about it – GDP has suffered. The estimates I have seen range from 1 to 2 percentage points, and that’s a lot of money – over Rs 2 lakh crore and maybe approaching Rs 2.5 lakh crore.”
He points out other costs as well: “The hassle cost of people standing in line, the printing cost that the RBI says is close to Rs 8,000 crore, the cost to the banks of withdrawing the money, and the time spent by their clerks, by their managers and by their senior officers doing all this, and the interest being paid on all those deposits, which earlier were effectively an interest-free loan to the RBI.”
An argument is being made that in the period April to June 2017 the growth fell because of the Goods and Services Tax which was supposed to be introduced on July 1, 2017. That is really not true. (you can read about it in detail here).
Also, even this fall in growth may not capture the situation completely given that the informal sector suffered the most because of demonetisation, and the GDP calculation does not capture that well enough.
All in all, demonetisation was a massive flop. It was an act of self-destruction that has hurt the Indian economy majorly and put us back by at least 1.5 to two years, on the economic growth front. This is something that India can ill-afford given the fact that 1.2 crore youth are entering the workforce every year.
Why I continue to write about demonetisation
People have been telling me the real aim of demonetisation was political, so why am I going on and on about the economic impacts.
I am not a dolt I understand that.
The subject of economics before it got hijacked by mathematicians was called political economy. The only place where economics and politics are different things are in an economics classroom or an economics textbook.
Hence, all political moves have economic impacts and vice versa, irrespective of what politicians and economists like to believe.
Also, will demonetisation negatively impact the Modi government, is a question I am being asked. I don’t know. But it has been a huge negative for the Indian economy, a problem which in the normal scheme of things, we wouldn’t have had to deal with.
And given that it needs to be highlighted and talked about, irrespective of whether it has made Modi politically stronger or weaker. That only time will tell. So, keep watching this space.
To conclude, I am a full-time writer and I am paid to write. I can’t do anything else. This is an honest way to make a living. So, I write.
Nostalgia is a funny thing. It makes you remember the good things you had and the good things you lost along the way (with due apologies to Bob Marley!).
The finance minister Arun Jaitley recently said: “(The) housing market in India, it had picked up. During Mr Vajpayee’s government, bank rates had come down to such an advantageous level that it was easier to buy an apartment than rent it out. That sort of situation had existed where the EMI has been reasonable. I think that’s the direction in which we have to slowly push our economy.” Jaitley said this at The Economist India Summit 2016, earlier this month, in response to a query on how the government plans to improve the stressed housing market.
What did Jaitley really mean here? First and foremost, he was remembering the good old days of the Vajpayee government (between 1998 and 2004). During those days the rent one had to pay while renting a house, was very close to the EMI one would have had to pay by taking on a home loan and buying it instead.
The question is how did this happen? This is something that Jaitley did not tell us. And one can’t blame him for it, given that there is only so much that one can say in response to a query. The real estate market had seen a boom in the 1990s. By the late 1990s the market had started to crash and kept unravelling over the next few years. Then the dotcom bubble burst in 2000-2001, the stock market fell after the Ketan Parekh scam came to light and the real estate prices crashed.
Hence, for the period that Vajpayee ruled the country, real estate prices were reasonable. In fact, as late as 2005 (a year after Vajpayee lost the 2004 Lok Sabha elections), property prices, even in Mumbai suburbs were fairly reasonable.
So, the EMI was low because the prices were low and it had nothing to do with lower interest rates. Also, as I have often said in the past, lower interest rates aren’t going to make any difference to Indian real estate. Let’s understand this through an example. Let’s say the property you are looking to buy costs Rs 80 lakh. The bank gives a home loan of 80 per cent against the market price of the home. This amounts to Rs 64 lakh (80 per cent of Rs 80 lakh). The downpayment that will have to be arranged for is Rs 16 lakh. The home loan is for a period of 20 years and the interest to be paid on it amounts to 10 per cent per year. (The prevailing home loan rate is around 9.5 per cent. But we will work with 10 per cent just for the ease of calculation).
The EMI on this amounts to Rs 61,761. Let’s say the interest rate on home loans falls (the reasonable EMIs that Jaitley was talking about). Let’s say the interest rate falls by a fourth to 7.5 per cent per year. The EMI will fall to Rs 51,558. This will mean a saving of around Rs 10,203 per month.
Of course, the home becomes more affordable if such a thing were to happen and home loan interest rates were to fall by a fourth.
Now let’s take a look a scenario where home prices fall by a fourth or 25 per cent. The value of the property falls to Rs 60 lakh. The bank now gives a loan of Rs 48 lakh (80 per cent of Rs 60 lakh). This would automatically make more people eligible for the loan than there were when the home loan of Rs 64 lakh had to be taken. The downpayment required falls to Rs 12 lakh. This is Rs 4 lakh lower than the Rs 16 lakh downpayment required earlier, making things significantly easier.
What about the EMI? At 10 per cent per year and for a period of 20 years, it works out to Rs 46,321. This is more than Rs 15,000 per month lower than the earlier EMI of Rs 61,761. Even at 7.5 per cent, the difference in the EMIs comes to close to Rs 13,000 per month. Also, it requires a lower downpayment of Rs 4 lakh. Further, at a lower value of the home, more people would be eligible for the loan, as a lower EMI needs to be paid. A lower EMI can be paid with a lower income.
Also, in this transaction I haven’t assumed a black component, to keep things simple. But if prices fall, the black component also comes down. Also, I feel a 25 per cent fall, as has been assumed here, will not make much of a difference, the prices need to fall more than that.
The point being if Indian real estate has to get back, prices need to come down. Let’s take the argument forward. Mr Jaitley talks about an era where rents and EMIs were equal. Now, what would it take for the rents to be equal to the EMI, in the time that we live in.
Let’s take the same example again. The value of the home is Rs 80 lakh. The rental yield (rent divided by the market price of the home) these days is around 2-3 per cent. Let’s take the upper end of 3 per cent. At 3 per cent on a home worth Rs 80 lakh, the rent works out to Rs 2,40,000 per year or Rs 20,000 per month.
If one were to buy this house, the bank would give a home loan of Rs 64 lakh (80 per cent of Rs 80 lakh). The EMI on this would work out to Rs 59,656. (Now we assume the real prevailing home loan interest of 9.5 per cent per year).
Over and above this, the buyer would also have to pay Rs 16 lakh as a downpayment. This means that this money will no longer be available for investment. If the buyer had this money in a fixed deposit which paid around 7 per cent per year, this would mean letting go of interest of Rs 1,12,000 per year or around Rs 9,333 per month. Hence, the total opportunity cost of buying a house worth Rs 80 lakh works out to Rs 69,989 per month.
Now compare this to the rent of Rs 20,000 per month. What this tells us very clearly is that renting is a no-brainer as of now, as far as numbers are concerned. Of course, there are other problems associated with renting which an owned home does not have.
If the rent has to be equal to the EMI plus the interest lost on the downpayment, then it has to go up by nearly 3.5 times its current levels. If it has to be equal to the EMI, then the rent has to go up around 3 times. The other option is that the property prices need to crash big time so that EMIs come down dramatically and are equal to the rent. Both options can be ruled out.
What will happen instead is that rents will rise gradually and property prices will fall gradually, in the years to come, but not dramatically (given that there are too many vested interests at work).
Only that is a given.
What this really tells us is that the finance minister Jaitley’s dream of a time where rents are close to EMIs, will remain a pipe dream at best, unless the real estate prices crash big time. Also, there is a fundamental disconnect here, the cost of owning something has to be greater than the cost of renting it.
On Saturday, August 20, 2016, the Narendra Modi government appointed Urjit Patel, as the 24th governor of the Reserve Bank of India(RBI). He will take over fromRaghuram Rajan, on September 4, 2016.
Since Patel’s appointment two days back, a small cottage industry has emerged around trying to figure out what his thinking on various issues is. The trouble is that Patel has barely given any speeches, or interviews, for that matter, since he became the deputy governor of the RBI, in January 2013.
A check on the speeches page of the RBI tells me that he has given only one speech (you can read it here) and one interview (you can read it here) in the more than three and a half years, he has been the deputy governor of the RBI.
You can’t gauge much about his thinking from the speech which is two and a half pages long. As far as the interview goes, Patel has answered all of three questions. Some of his thinking can be gauged from the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework¸ of which he has the Chairman. The report was published in January 2014 and ultimately became the basis for the formation of the monetary policy committee, which will soon become a reality.
There are also a few research papers that he has authored over the years.
Given this, Patel’s thinking on various issues will become clearer as we go along and as he interacts more with the media in the days to come. While he may have managed to avoid the media in his role as the deputy governor that surely won’t be possible once he takes over as the RBI governor. He may not make as many speeches as his predecessor did (which is something that the Modi government probably already likes about him), but there is no way he can avoid interacting with the press, after every monetary policy statement, and giving interviews now and then.
Given this, the policy continuity argument being made across the media about Patel being appointed the RBI governor, is rather flaky. There isn’t enough evidence going around to say the same. The only thing that can perhaps be said from what Patel has written over the years is that his views on inflation seem to be in line with Rajan’s thinking. Also, some of the stuff that is being cited was written many years back. And people do change views over the years. There is no way of knowing if Patel has.
The Challenges for the new RBI governor
While, his thinking on various issues may not be very clear, it doesn’t take rocket science to figure out what his bigger challenges are. Take a look at the following chart. It maps the inflation as measured by the consumer price index since August 2014.
The chart tells us very clearly that the inflation as measured by the consumer price index is at its highest level since August 2014. In August 2014, the inflation was at 7.03 per cent. In July 2016, it came in at 6.07 per cent.
Like the inflation as measured by the consumer price index, the rate of food inflation is also at its highest level since August 2014. In August 2014, the food inflation was at 8.93 per cent. In July 2014, the food inflation was at 8.35 per cent. Food products make for a greater chunk of the consumer price index.
What this tells us is that the inflation as measured by the consumer price index spikes up when the food inflation spikes up. And that is the first order effect of high food inflation. This becomes clear from the following chart.
But what can the RBI do about food inflation?
There is not much that the RBI can do about food inflation. And this is often offered as a reason, especially by the corporate chieftains and those close to the government (not specifically the Modi government but any government), for the RBI to cut the repo rate. The repo rate is the rate of interest that the RBI charges commercial banks when they borrow overnight from it. It communicates the policy stance of the RBI and tells the financial system at large, which way the central bank expects interest rates to go in the days to come.
The trouble is that things are not as simplistic as the corporate chieftains make them out to be. While, the RBI has no control over food inflation (and not that the government does either), it can control the second-order effects of food inflation.
As D Subbarao, former governor of the RBI, writes in his new book Who Moved My Interest Rate?-Leading the Reserve Bank of India Through Five Turbulent Years: “What about the criticism that monetary policy is an ineffective tool against supply shocks? This is an ageless and timeless issue. I was not the first governor to have had to respond to this, and I know I won’t be the last. My response should come as no surprise. In a $1500 per capita economy-where food is a large fraction of the expenditure basket-food inflation quickly spills into wage inflation and therefore into core inflation…When food has such a dominant share in the expenditure basket, sustained food inflation is bound to ignite inflationary expectations.”
Given this, the entire logic of the RBI cutting the repo rate because it cannot manage food inflation is basicallybunkum. Food inflation inevitably translates into overall inflation and that is something that the RBI has some control over, through the repo rate. If this is not addressed, second order effects of food inflation can lead to an even higher inflation as measured by the consumer price index. And this will hurt a large section of the population.
As Subbarao writes: “The Reserve Bank of India cannot afford to forget that there is a much larger group that prioritizes lower inflation over a faster growth. This is the large majority of public comprising of several millions of low-and-middle-income households who are hurt by rising prices and want the Reserve Bank to maintain stable prices. Inflation, we must note, is a regressive tax; the poorer you are, the more you are hurt by rising prices.”
But one cannot expect corporate chieftains who have taken on a huge amount of debt over the years, in order to further their ambitions, to understand this rather basic point. Given this, this hasn’t stopped them from demanding a repo rate cut from the new RBI governor. (You can read more about it here). The government has also made it clear over and over again that it wants the RBI to cut the repo rate. Given that, it is the biggest borrower, this is not surprising. Since January 2015, the RBI has cut the repo rate by 150 basis points to 6.5 per cent. One basis point is one hundredth of a percentage.
As Subbarao writes: “The narrative of our growth-inflation debate is also shaped by what I call the ‘decibel capacity’. The trade and the industry sector, typically a borrower of money, prioritizes growth over inflation, and lobbies for a softer interest-rate regime.”
The people who invest in deposits unlike the corporate chieftains are not in a position to lobby. But it is important that the RBI does not forget about them.
Hence, it is important that people are offered a positive real rate of interest on their fixed deposits. The real rate of interest is essentially the difference between the nominal rate of interest offered on fixed deposits and the prevailing rate of inflation. A positive real rate of interest is important in order to encourage people to save and build the domestic savings of India, which have been falling over the last few years.
This was one of the bigger mistakes made during the second-term of the Manmohan Singh government.
As outgoing governor Raghuram Rajan told NDTV in an interview sometime back “When inflation was 9 per cent they [i.e. depositors] were getting 9 per cent. This meant earning nothing in real terms and losing everything in inflation.”
This wasn’t the case for many years. As Rajan explained in a June 2016 speech: “In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.”
Inflation up, savings down
Take a look at the following chart clearly shows that between 2008 and 2013, the real rate of return on deposits was negative. In fact, it was close to 4 per cent in the negative territory in 2010.
High inflation essentially ensured that India’s gross domestic savings have been falling over the last decade. Between 2007-2008 and 2013-2014, the rate of inflation as measured by the consumer price index, averaged at around 9.5 per cent per year. In 2007-2008, the gross domestic savings peaked at 36.8 per cent of the GDP. Since then they have been falling and in 2013-2014, the gross domestic savings were at 30.5 per cent of the GDP, having improved from a low of 30.1 per cent of GDP in 2012-2013.
This fall in gross domestic savings has come about because of a dramatic fall in household financial savings. Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.
Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6 per cent of the GDP. In 2009-2010, it rose to 12 per cent of GDP. By 2011-2012, it had fallen to 7 per cent of the GDP. The household financial savings in 2014-2015, stood at 7.5 per cent of GDP. Chances of this figure having improved in 2015-2016 are pretty good given that a real rate of return on deposits is on offer for savers, after many years.
If a programme like Make in India has to take off, India’s household financial savings in particular and overall gross domestic savings in general, need to be on solid ground. And that is only going to happen if people are encouraged to save by ensuring that they make a real rate of return on their deposits. In fact, if India needs to grow at 10 per cent per year, an estimate made in Vijay Joshi’s book India’s Long Road suggests that the savings rate will have to be around 41 per cent of the GDP.
As Rakesh Mohan and Munish Kapoor of the International Monetary Fund write in a research paper titledPressing the Indian Growth Accelerator: Policy Imperatives: “In the near future, we expect financial savings to be restored to the earlier 10 per cent level, as inflation subsides, monetary conditions stabilize and households begin to obtain positive real interest rates on their deposits and other financial savings. Financial savings are then projected to increase gradually to around 13 per cent by 2027-32.”
And how is this going to happen? As Mohan and Kapoor point out: “A sustained reduction in inflation that leads to the maintenance of low nominal interest rates, but positive real interest rates, will help in restoring corporate profitability, while encouraging household savings towards financial instruments.”
As can be seen from the graph, the difference between the repo rate (the orange line) and overall inflation (i.e. inflation as measured by the consumer price index) has narrowed considerably and is at its lowest level in the last two years. This effectively means that the real rate of return on fixed deposits offered by banks has been falling as the rate of inflation has been going up. (Ideally, I should have taken the average rate of return on fixed deposits instead of the repo rate, but that sort of data is not so easily available. Hence, I have taken the repo rate as a proxy).
This is not a good sign on several counts. In a country like India where deposits are a major way through which people save, high inflation leading to lower real rates of interest which effectively means that they are not saving as much as they should. This is something that most people do not seem to understand.
The economist Michael Pettis makes a very interesting point about the relationship between interest rate and consumption in case of China. As he writes in The Great Rebalancing: “Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”
Now replace China with India in the above paragraph and the logic remains exactly the same. Given that a large portion of the Indian household financial savings are invested in bank deposits, any fall in interest rates (as the corporate chieftains regularly demand) should make people feel poorer and in the process negatively impact consumption, at least from the point of savers.
Given this, the biggest challenge for Urjit Patel will be to not taken in by all these demands for lower interest rates and ensure that the deposit holders get a real rate of interest on their fixed deposits.
Further, it is unlikely that he will cut the repo rate given that as the monetary policy committee comes in place, the RBI needs to maintain a rate of inflation between 2 to 6 per cent. In July 2016, the rate of inflation was over 6 per cent.
The finance minister, Arun Jaitley is at it again, demanding lower interest rates. As he said, late last week: “Now, whether domestic savings are only to be used by such instruments which give you a higher return and create an interest regime which is extremely costly and makes the economy sluggish, or higher returns are to be got from such instruments as funds, bonds, shares.”
Jaitley further said: “A lot of them have also an element of secured investment in them which can give people a very respectable return itself.”
Normally, Jaitley’s statements on interest rates in the past have been as straightforward as, I demand lower interest rates. But this time around, he has made a long and a convoluted statement, which basically means the same.
So what Jaitley is saying here is that people save money with banks. The interest rates on bank fixed deposits are high. Given that interest rates on bank fixed deposits are high, the interest rates on bank loans are high. Since interest rates on bank loans are high, people and companies are not borrowing, and this makes the overall economy sluggish.
Hence, people should be investing their money in mutual funds, bonds and shares that finance projects and economic activity.
This is what happens when people make statements without looking at numbers. In fact, growth in retail lending carried out by banks in 2015-2016, has been the highest since 2009-2010. So clearly retail lending is growing at a very robust pace. The so called high interest rates on bank lending, clearly hasn’t had much of an impact on this front.
Retail lending growth
March 20, 2015 to March 18, 2016
March 21, 2014 to March 20, 2015
March 22, 2013 to March 21, 2014
March 23, 2012 to March 22, 2013
March 25, 2011 to March 23, 2012
March 26, 2010 to March 25,2011
March 27, 2009 to March 26, 2010
Source: Sectoral Deployment of Credit Data, RBI
The problem has been in bank lending to industry. The lending growth to industry in 2015-2016 slowed down to around 2.7 per cent. In comparison, it grew by more than 23 per cent, during the go go years between 2009 and 2011. But a lot of that lending was to crony capitalists.
Banks have not been lending to industry, because of all the bad loans that they have accumulated on the lending to industry, in the past. Also, many corporates continue to be heavily leveraged, even though things did improve a little in 2015-2016.
As the RBI Financial Stability Report released in late June points out: “An analysis of the current trends in debt servicing capacity and leverage of ‘weak’ companies [defined as those having interest coverage ratio (ICR)<1]was undertaken…[It] indicated some improvement in 2015-16. The analysis shows that 15.0 per cent of companies were ‘weak’ in the select sample as at end March 2016, compared to 17.8 per cent in March 2015. The share of debt of these ‘weak’ companies also fell to 27.8 per cent of total debt in the second half of 2015-16 from 29.2 per cent in the second half of 2014-15. However, the debt to equity ratio of these ‘weak’ companies increased to 2.0 from 1.8.”
Interest coverage ratio is the ratio of the earnings before interest and taxes of a company during a period divided by the interest that it needs to pay on its accumulated debt during the same period. This basically reflects the ability of the company to finance its debt. An interest coverage ratio of less than one basically means that the company is not making enough money to be able to repay the interest on its accumulated debt.
The RBI categorises these companies as weak companies. The proportion of these companies fell to 15 per cent as on March 31, 2016, in comparison to 17.8 per cent earlier. Nevertheless, these companies still had around 27.8 per cent of the total bank debt. Further, their debt to equity ratio deteriorated to 2 from 1.8.
Given that many companies continue to be highly leveraged along with the fact that they are not making enough money to be able to service their accumulated debt, it is but natural that banks do not want to lend to these companies.
The purpose of any bank is not to get the economy going by lending. It is to lend money to customers who are likely to return it. At the same time, they need to charge an adequate rate of interest, which basically takes the credit risk (or the chances of a default) of customers into account.
Also, Jaitley’s statement seems to suggest that corporates are just waiting to borrow money and expand. And the high interest rates of banks are stopping them from doing so. The data clearly suggests otherwise.
As per the Order Books, Inventories and Capacity Utilisation Survey (OBICUS) survey carried out by the RBI, for the period October to December 2015, the capacity utilisation of 1,058 manufacturing companies which responded to the survey, stood at 72.5 per cent. This was slightly better than the period July to September 2015, when it had stood at 71.4 per cent.
But on the whole capacity utilisation continues to be low. More than one fourth of manufacturing capacity is still not being used. In fact, the situation is even worse than this in some sectors. As Manasi Swamy of the Centre for Monitoring Indian Economy points out in a research note titled Why should manufacturers invest more?: “Large manufacturing industries like cement, steel, sponge iron and aluminium worked at an estimated capacity utilisation of 65 per cent or lower in 2015-16. Automobile companies too have enough capacity to meet any increase in demand. The passenger cars industry is running at 63 per cent capacity utilisation level, two-wheelers at 76 per cent, commercial vehicles at as low as 37 per cent and tractors at 63 per cent. Capacity utilisation levels in industries like paper and textiles are also quite low.”
Over and above this, the return on capital employed for the manufacturing sector has fallen from 11.7 per cent in 2006-2007 to 3.8 per cent in 2014-2015, Swamy points out. In this scenario it is safe to say that industry is also not interested in borrowing more to expand. They may welcome lower interest rates because that will help them service their existing debt in a better way. But that is another issue altogether.
Also, Jaitley seems to suggest that investing in stocks and mutual funds leads to entrepreneurs being able to raise capital. This doesn’t hold true anymore. Public issues these days are basically about investors trying to sell out their stakes in companies. It is rarely about entrepreneurs funding expansion by selling shares. These investors can be venture capitalists, private equity firms or even the government.
Further, banks raise deposits to give out loans. And these loans are also helpful for the economy. If retail lending is growing at close to 20 per cent, it is benefiting vehicle companies, consumer durable companies, as well as real estate companies. What about that? How is that not helping the economy?
Also, the basic question that Jaitley needs to answer is that if the Indian economy grew by 7.6 per cent in 2015-2016, how is the economic growth sluggish? The finance minister cannot have it both ways. When he wants to project the government in good light he says, India is the fastest growing major economy in the world. When he wants lower interest rates and show the RBI in a bad light, he says the economic growth is sluggish.
Another point I wanted to make is that the government can play a huge role in bringing down interest rates further. Currently, the difference between fixed deposit interest rates and the interest rate offered on post office small savings schemes is anywhere from 40 to 160 basis points. One basis point is one hundredth of a percentage. Banks compete with post office schemes when it comes to taking on deposits and cannot keep cutting interest rates on deposits beyond a point.
Further, I think Mr Jaitley must clearly not have forgotten all the ruckus that was created when the government tried to cut the interest rate on the Employees Provident Fund(EPF) by 5 basis points to 8.7 per cent. This would have meant that contributors to the EPF would have got a lower interest of Rs 50 less per lakh, during the course of the year. To break it down further, it would have meant a lower interest of Rs 4.5 per month per lakh, for those who contribute to the EPF. The government couldn’t even push this through.
The current interest rate on EPF is 8.8 per cent. This is close 100-180 basis points higher than the interest rate on fixed deposits, without taking into account that interest rate on fixed deposits is taxed, whereas interest on EPF is tax free. Why should there be such a huge difference in interest rates? How about some fairness on this front Mr Jaitley?
Of course, those who contribute to EPF are an organised lot and can create a lot of hungama if the government decides to cut the interest rate. The same cannot be said for a normal depositor who is placing his money in the bank in the hope that it grows in the years to come. The depositors do not have a union and hence, it’s easy to take them for a ride.