Michael Pettis

Why RBI Should Not Cut Interest Rate by 1%

 

RBI-Logo_8

In an interesting The Honest Truth column which was recently published, Ajit Dayal writes: “I think the RBI may charge ahead with a 100 basis points cut!” One basis point is one hundredth of a percentage. Hence, 100 basis points amount to 1%.

The Reserve Bank of India(RBI)’s next monetary policy statement is scheduled for April 5, 2016.

Dayal offers multiple reasons on why he thinks the RBI may cut the repo rate by 1%. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the short and medium term interest rates in the economy. I would highly recommend that you read Dayal’s column before you start reading mine.

The stock market wallahs always want lower interest rates because they believe that lower interest rates take the stock market to higher levels. The logic is that at lower interest rates people will borrow and spend more. They will buy more two-wheelers, cars, consumer durables and homes, and this will benefit companies. With this increase in consumption, earnings of companies are likely to go up, and the stock prices will adjust for it.

Further, it will also benefit companies which have a huge amount of debt. They will have to pay a lower amount of interest to service their existing debt. Third, the banks will benefit from the huge bond portfolios that they have.

As Dayal writes: “A 1% cut in interest rates would boost the value of the bond portfolios of banks by 10% to 15%. So, for every Rs 100,000 crore of bonds held by the banks, there will be a possible Rs 12,000 crore to Rs 15,000 crore surge in the net worth of the bank.”

Interest rates and bond prices are inversely related. As interest rates fall, bond prices go up. This is because investors want to stock up on bonds issued earlier, which pay a higher interest. This drives up the price of these bonds. As prices go up, this benefits banks which already own these bonds and they make higher profits.

While these reasons make sense, they present only a part of the picture. In this column, the point I will make is exactly the opposite of what Dayal is making i.e. RBI should not cut the repo rate by 1%, or at least not all at once.

There are multiple reasons for the same. First and foremost, the RBI cutting the repo rate is just a part of the process of the overall interest rates coming down. When the RBI cuts the repo rate, the banks need to pass on the cut to their borrowers as well. This happens by the banks cutting their deposit rates as well as their lending rates.

But what has happened in the Indian case is that banks have cut their deposit rates without cutting their lending rates at the same pace. As RBI governor Raghuram Rajan had said in December 2015 “Since the rate reduction cycle that commenced in January [2015], less than half of the cumulative policy repo rate reduction of 125 basis points has been transmitted by banks. The median base lending rate has declined only by 60 basis points.”

So a 100 basis points cut by the RBI will lead to banks cutting the interest rates on their deposits without cutting their lending rates at the same rate. Historically this is what banks have always done and there is no reason to believe that this time will be any different.

And this is not a good thing. Hence, it is best that the RBI cut the repo rate in a gradual way, 25 basis points at a time, wait to see whether the banks pass on the cut and then move further.

A new marginal cost based lending rate comes into the picture for banks from April 1, 2016. The RBI needs to wait to see how this pans out and whether banks actually go about cutting interest rates on their loans, as they are expected to.

Also, many economists and analysts look at interest rates just from the point of view of the borrower. But what about the saver? If the interest rates are cut dramatically the saver will have to save more to meet his or her financial goals, in the years to come. How about taking that into account as well?

Deposits with banks, non-banking companies and cooperative banks and societies, form a major part of household financial savings of Indians. In 2011-2012, 2012-2013 and 2013-2014, deposits formed 58%, 56% and 69% of the total household financial savings. Banks deposits made up for 53%, 50% and 62% of the total household financial savings. (The breakup for 2014-2015 is not available).

Hence, interest rates need to be viewed from the point of view of savers as well, given that a major part of savings are in bank deposits. 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.”

Given that a large portion of the Indian household financial savings are invested in bank deposits, any fall in interest rates should make people feel poorer and in the process negatively impact consumption, at least from the point of savers.

Also, people who are savings towards a goal will have to save more. Pettis explains this in his book through an example that one of his students told him about. As he writes: “According to my student, her aunt was planning to save a fixed amount of money for when her twelve-year-old son turned eighteen and was slated to go university. She had a certain amount of money already saved, but not enough, so she needed to add to her savings every month to achieve her target.”

A similar logic applies in the Indian case as well and needs to be taken into account whenever we talk about lower interest rates.

Rajan has often said in the past that he wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.

The consumer price inflation on which the RBI bases its monetary policy on, in February 2016, stood at 5.2%. If we add 1.5% to this, we get 6.7%, which is more or less similar to the prevailing repo rate. The current repo rate stands at 6.75%.

The last time I used this argument some readers on the social media pointed out that instead of using the repo rate, I should have used the interest rate on fixed deposits to make this argument.

I used the repo rate because that is what the RBI does. As a February 2016 newsreport of the PTI points out: “Deputy Governor Urjit Patel also defended the RBI move to take into account the repo rate, and not the deposit rates, while computing the real rate of interest, saying the rate set by RBI is a universal one which is relevant for the entire country.”

Nevertheless, let’s take the case of the interest rate that the State Bank of India pays on its fixed deposits for a period of 5-10 years. The interest rate is 7%.

The latest consumer price inflation is 5.2%. If we to add 1.5% to this, we get 6.7%. The SBI interest rate is 7%. Hence, there is a scope for 25 basis point repo rate cut from the RBI, if we use the bank fixed deposit interest rate to calculate the real rate of interest.

The interest rate offered by SBI on a fixed deposit of a tenure two years to less than three years, is 7.5%. If were to consider this while calculating the real rate of interest, then there is a scope for a 75 basis points rate cut by the RBI.

It is important that a real rate of interest of 1.5-2% is maintained in order to drive up the rate of household financial savings. In 2007-2008, the household financial savings had stood at 11.2% of the gross domestic product (GDP). By 2011-2012, they had fallen to 7.4% of GDP. Since then they have risen marginally. In 2014-2015, the household financial savings stood at 7.7% of GDP. This needs to go up.

This column originally appeared on the Vivek Kaul Diary on March 30, 2016

Chinese Growth is Bad for Global Economy

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In yesterday’s edition of the Diary I talked about how Chinese banks have unleashed another round of easy money, in order to push up economic growth. The Chinese economic growth for 2015 was at 6.9% which is a two-decade low. Many China watchers and economists believe that the real economic growth is significantly lower than this number and is likely to be more in the region of 4-5%.

In order to push up economic growth Chinese banks lent out a whopping 2.5 trillion yuan (around $385 billion) in January 2016, the highest they ever have during the course of a month. This increased borrowing and spending if it continues, as it is likely to, will lead to creation of more capacity in China.
The creation of this excess capacity will provide a short-term fillip to the Chinese economic growth as more infrastructure, homes and factories get built. The trouble is that the Chinese economy is unlikely to absorb the creation of this excess capacity.

As Satyajit Das writes in The Age of Stagnation: “China continues to add capacity to maintain growth. If it is unable to absorb this new capacity domestically, it might seek to increase exports to maintain production and growth. This would exacerbate global supply gluts and increase deflationary pressures in the global economy.” Deflation is the opposite of inflation and essentially means a scenario of falling prices.

Household consumption as a proportion of the Chinese economy has fallen over the years. In 1981, household consumption made up for 51.7% of the gross domestic product(GDP). Starting in 1990, the household consumption as a proportion of the Chinese economy started to fall and by 1999, it was at 45.6% of the GDP.

By 2009, the number had fallen to 35.3% of the GDP. In 2014, the household consumption to GDP ratio stood at 36.6%, not very different from where it was in 2009.

What does this tell us? As Michael Pettis writes in The Great Rebalancing—Trade, Conflict and the Perilous Road Ahead for the World Economy: “In any economy there are three sources of demand—domestic consumption, domestic investment, and the trade surplus—which together compose total demand, or GDP. If a country has a very low domestic consumption share, by definition it is overly reliant on domestic investment and trade surplus to generate growth.” Trade surplus is essentially the situation where the exports of a country are more than its imports.

This is precisely how it has played out in China. In 1981, the Chinese investment to GDP ratio was at 33%. In 2014, the number stood at 46%. What does this tell us? By limiting consumption, the Chinese were able to create savings. These savings were then diverted into investments and the investment created excess capacity in the Chinese economic system. In 1982, the Chinese savings had stood at 35% of the GDP. By 2013, Chinese savings had jumped to 50% of the GDP. The investment to GDP ratio during the same year stood at 48%.

The excess capacity was taken care of by exporting more. And that is how the Chinese economic growth model worked all these years. What this means that with a low consumption rate, the Chinese have always been more dependent on investment and exports to create economic demand. In the 1980s and 1990s, the high rate of investment made immense sense, when China lacked both infrastructure as well as industry. But over the years China has ended up overinvesting and creating excess capacity, and in the process become overly dependent on exports, if it wants to continue to grow at a fast rate.

As Pettis writes: “With consumption so low, it would mean that China was overly reliant for growth on two sources of demand that were unsustainable and hard to control. Only by shifting to higher domestic consumption could the country reduce its vulnerability and ensure rapid economic growth. This is why in 2005, with household consumption at a shockingly low 40 percent of GDP, Beijing announced its resolve to rebalance the economy toward a greater consumption share.”

In 2014, the household consumption to GDP ratio stood at 36.6%. Hence, the shift towards consumption driving economic growth has clearly not happened. The point being that the country is now addicted to the investment-exports driven growth model. In this scenario, every time there is a slowdown in economic growth, China resorts to the tried and tested investment led economic growth model. And the first step in this model is to get banks to lend more.

As Pettis writes: “The decision to upgrade is politically easy to make because each new venture generates local employment, rapid economic growth in the short term, and opportunities for fraud and what economists politely call rent-seeking behaviour, while costs are spread through the entire country through the banking system and over the many years during which the debt is repaid.”

This explains why Chinese banks lent 2.5 trillion yuan in January 2016, the most that they ever have. The trouble is that this round of economic expansion will lead to more excess capacity. And this will lead to a push towards higher exports and in the process hurt the global economy.

As Pettis writes: “China is not currently the engine of world growth. With its huge trade surplus, it actually extracts from the world more than its share of what is now the most valuable economic source in the world—demand. A rebalancing will mean a declining current account surplus and reduction of its excess claim on demand. This will be positive for the world.”

What Pettis basically means is that the Chinese household consumption to GDP ratio needs to go up i.e. the Chinese need to consume more of what they produce. But recent evidence clearly suggests that the Chinese government has no such plans and the investment-exports driven led economic growth strategy is likely to continue.

The column originally appeared in Vivek Kaul’s Diary on February 23, 2016

Do Lower Interest Rates Revive Consumption? Not Always

ARTS RAJAN
The Reserve Bank of India governor Raghuram Rajan presented the sixth monetary policy statement for this financial year, earlier this month. In the policy he decided to maintain the status quo and not change the repo rate. Repo rate is the rate at which RBI lends to banks, which acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

After the policy, the representatives of the industry protested and said that they were expecting a repo rate cut, which would revive consumption as well as investments. As Chandrajit Banerjee, director of business lobby CII, said: “A rate cut would have been spot-on for rejuvenating the investment cycle. We hope RBI would resume the rate-cutting cycle in the subsequent monetary policy soon after the Union Budget to complement the government’s efforts to revive private investments and bring the economy back to sustained growth.”

Getamber Anand, president of real estate lobby CREDAI, echoed Banerjee’s sentiments, when he said: “We are very disappointed. We were expecting a 25 basis points reduction in the repo rate.” He also said that home loan interest rates should be lower than 9%.

The belief is that at lower interest rates people borrow and spend more, and industries also invest more. This sounds very convincing but is essentially very simplistic thinking that lobbyists try to peddle.

Conventional thinking assumes a negative relationship between consumption and interest rates. But that is also a function of how people save money. Michael Pettis in his book The Great Rebalancing—Trade, Conflict, And the Perilous Road Ahead for the World Economy makes a very interesting point about China.

As he writes: “Most Chinese savings, at least until recently, have been in the form of bank deposits. In a financial system in which deposit rates are set by the central bank, the value of bank deposits is positively, not negatively, correlated with the deposit rate. 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.”

Given that a large portion of the financial savings are invested in bank deposits, any rise in interest rates should make people feel richer and in the process make them consume more.

Vice versa, any fall in interest rates should make people feel poorer and lead to lower consumption. Further, if the interest rate on deposits is lower than the rate of inflation, or around the rate of inflation, or not substantially different from the rate of inflation, any rise in interest rates should lead to a higher consumption.

As Pettis writes: “If deposit rates do not reflect market conditions—most important, inflation rates…then bank deposits, who measure their wealth in terms of the expected real return on their depositors, should welcome rising rates and deplore declining rates.  The former should make them feel richer and so increase their consumption and the latter make them feel poorer.”

This is something that is largely applicable to India as well. While the central bank does not set interest rates on fixed deposits as such, large portions of household financial savings are invested in bank deposits, provident and pension fund schemes (with a significant portion of these schemes being run by the post office). In these investments, as interest rates go up, people feel richer.

In 2012-2013, the 54.4% of household financial savings were in bank deposits and provident and pension fund schemes. Nearly 16.2% of household financial savings were held in the form of cash. Only 6.62% of household financial savings were invested in stocks and debentures. 24.4% of the savings were invested in life insurance, where it is next to impossible to figure out what returns to expect.

In 2011-2012, 56.7% of the household financial savings were invested in bank deposits and provident and pension fund schemes. In 2010-2011, 51% of the savings were invested in deposits and provident and pension fund schemes.

The point being that a major portion of household financial savings get invested in bank deposits and pension and provident fund schemes. This means when interest rates go up or are high, people are more likely to spend more.

Also, the another point that people forget is the multiplicity of needs. Not everyone is looking to borrow and spend when interest rates fall. As Malhar Nabar writes in an IMF Working Paper titled Targets, Interest Rates, and Household Saving in Urban China: “China’s households save to meet a multiplicity of needs – retirement consumption, purchase of durables, self-insurance against income volatility and health shocks – and act as though they have a target level of saving in mind. An increase in financial rates of return, which raises the return on saving, makes it easier for them to meet their target saving.”

This is a point that needs to be taken into account. It applies as much to India as it does to China. People are trying to save money for emergencies as well their retirement, education and weddings of their children and so on. And this lot gets hurt every time the interest rate on their deposits goes down.

This means they need to save more and consume less when interest rates go down. Hence, lower interest rates do not lead to an increase in consumption for everybody. The truth is a lot more nuanced than that.

There is another point that needs to be made here. Between December 2014 and December 2015, the disbursal of personal loans (the term RBI uses for home loans, education loans, vehicle loans, loans against shares, bonds and fixed deposits, and what we call personal loans) went up by 16.1%. This after the RBI cut the repo rate by 125 basis points during the course of the year. One basis point is one hundredth of a percentage.

How good was the personal loan growth between December 2013 and December 2014? 15.3%.

Hence, the difference in personal loan growth for the one-year period ending December 2014 and the one-year period ending 2015 is not substantial, despite lower interest rates. One explanation for this lies in the fact that banks have not passed on the entire benefit of the repo rate cut to the end consumers.

The other reason lies in the fact that not everybody is looking to borrow. Those looking to save are hurt by lower interest rates and end up consuming lesser in order to meet their target saving. And this is a point that doesn’t get discussed enough, given that it isn’t so obvious.

The column originally appeared in the Vivek Kaul Diary on Equitymaster on February 11, 2016