Money illusion

Interest rates are also about savers, not just about borrowers

ARTS RAJAN

One of the points that I have made in the past is that interest rates are not just about borrowers; they are also about savers.

Raghuram Rajan, the governor of the Reserve Bank of India(RBI) explained this beautifully in a recent interview to NDTV. At a talk somewhere, one gentleman got up and told the governor that he should bring down the interest rates to 4%.

A point that most people fail to understand is that an RBI governor can decide only on the repo rate. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

The RBI governor does not decide on the interest rate that a bank charges on its loans. Neither does he decide the interest rate a bank pays on its deposits for that matter. That is a decision individual banks make.

Hence, Rajan cutting the repo rate is not enough. Banks need to pass on the cut to the end consumers. Since January 2015, Rajan has cut the repo rate by 150 basis points. Banks have passed on around half of that cut to the end consumers due to various reasons. The public sector banks have been accumulating a huge amount of bad loans and this has limited their ability to cut interest rates on their loans.

Rajan asked this gentleman that the rate of inflation was still 5.5% and if he brought down the interest rate to 4%, would he still deposit his money at the bank? The gentleman said no. So he was not willing to deposit his money at a low interest rate, but wanted banks to lower their lending rates.

To this Rajan said: “say a bank pays 6% on deposits and lends at 4%, who is going to make up for the difference”. “The idea is that somebody is going to pick up the tab. We are used to somebody picking up the tab. Who is going to pick up this tab?”

The point here is very simple. A bank can only lend at a rate of interest which is higher than the rate at which it borrows. Further, it needs to offer a certain rate of interest on its deposits, so that people deposit money with it and do not invest it in other avenues which offer a higher rate of return. Currently, the rate of interest offered on small savings schemes are significantly higher than those of fixed deposits.

Rajan also said that it takes some time for depositors to get used to the fact that inflation has actually come down over the last few years. “The real interest rate they [i.e. depositors] are getting now is much higher than the real interest rate they were getting earlier,” Rajan said.

The real interest rate is essentially the nominal interest rate offered by a bank on its fixed deposit subtracted by the prevailing rate of inflation. “When inflation was 9% they [i.e. depositors] were getting 9%. This meant earning nothing in real terms and losing everything in inflation,” Rajan explained. “Today they are getting 7% on their deposits and inflation is 5.5%. They are earning 1.5%. It is a real difference,” he added.

This is something that will take time to sink in because money illusion is at work. What is money illusion? As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes: “[Money illusion] involves a confusion between ‘”nominal” changes in money and “real” changes that reflect inflation…Accounting for inflation requires the application of a little arithmetic, which…is often an annoyance and downright impossible for many people…Most people we know routinely fail to consider the effects of inflation in their finance decision making.”

So, the point is that even though people are earning a better real rate of interest they don’t realise it. What they see is that nominal rate of interest has fallen and given this they are not happy with banks offering a lower rate of interest on their fixed deposits.

As Rajan said in the NDTV interview: “Depositors are already complaining that they are not getting enough. That is why banks are reluctant to cut [deposit] rates.” And unless banks can cut deposit rates there is no way they can cut lending rates, irrespective of what the RBI chooses to do with the repo rate.

This is how bank interest rates work. As Rajan asked: “For somebody to say that I have a God given right to get a loan at low interest rate but I won’t deposit at that rate, where is the money going to come from them?” This basically means that banks lend money they essentially get as deposits. And without deposits there is going to be no lending.

“One of the most difficult things in economics to understand is general equilibrium. You do one thing it has other effects as well,” Rajan said. If interest rate on lending is cut where is the money going to come for savings, Rajan asked.

This is something that people who keep demanding lower interest rate at a drop of a hat don’t seem to understand. There are two sides to bank interest rates. The interest rate banks charge on their loans and the interest rate they pay on their deposits. And if interest rates on deposits can’t fall beyond a point, then the interest rate on loans can’t fall as well.

This is a basic point that people don’t seem to understand. And it’s not rocket science.

The column was originally published in the Vivek Kaul Diary on June 10, 2016

Hold your fire! Govt cutting rates on PPF, small savings schemes is a good move; here’s why

rupee

The Narendra Modi government has cut the interest rates on offer on the public provident fund(PPF) and other small savings schemes run by the post office.

The new interest rates will come into play from April 1, 2016 and will be in effect until June 30, 2016. The interest rate on PPF has been cut from 8.7% to 8.1%. The interest on the Senior Citizens Savings Scheme has been cut from 9.3% to 8.6%.

InstrumentRate of interest w.e.f. 01.04.2015 to 31.3.2016Rate of interest w.e.f. 01.04.2016 to 30.6.2016
Savings Deposit4.04.0
1 Year Time Deposit8.47.1
2 Year Time Deposit8.47.2
3 Year Time Deposit8.47.4
5 Year Time Deposit8.57.9
5 Year Recurring Deposit8.47.4
5 Year Senior Citizens Savings Scheme9.38.6
5 Year Monthly Income Account Scheme8.47.8
5 Year National Savings Certificate8.58.1
Public Provident Fund Scheme8.78.1
Kisan Vikas Patra8.77.8 (will mature in 110 months)
Sukanya Samriddhi Account Scheme9.28.6

 

This decision to cut down interest rates hasn’t gone down well with the middle class. This has come soon after the Employees’ Provident Fund(EPF) fiasco where the government tried to tax the accumulated corpus of the private sector employees on contributions made after April 1, 2016.

While trying to tax EPF was incorrect, the hue and cry being made out on interest rates on PPF and small savings schemes being cut, is uncalled for. This is happening primarily because most people have become victims of what economists call the money illusion.

What is money illusion? As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes: “[Money illusion] involves a confusion between ‘”nominal” changes in money and “real” changes that reflect inflation…Accounting for inflation requires the application of a little arithmetic, which…is often an annoyance and downright impossible for many people…Most people we know routinely fail to consider the effects of inflation in their finance decision making.”

Hence, money illusion is essentially a situation where people don’t take inflation into account while calculating their return on an investment.

How does this apply to the current context? Let’s consider the Senior Citizens Savings Scheme. The interest rate on offer on the scheme was 9.3%. The rate of inflation that prevailed between 2008 and 2013 was 10% or more. Hence, the real rate of return on the scheme was negative. This was the case with other small savings schemes as well as bank fixed deposits.

In fact, the real rate of return was well into the negative territory. The real rate of return for a senior citizen who did not have to pay income tax on the earnings from the Senior Citizens Savings Scheme stood at minus 0.7% (9.3% minus 10%).

For those who had to pay income tax, the real rate of return was even lower. For those in the 10% tax bracket the real rate of return was minus 1.63% per year. For those in the tax 20% and 30% tax brackets, the real rate of return was minus 2.56% and minus 3.49%.

But back then no one complained about the interest rate being low, even though almost everyone who invested in PPF and other small savings, was losing money. The purchasing power of their investment was coming down.

The situation is totally different now. Inflation as measured by the consumer price index stood at 5.2% in February 2016. Given this, the real rate of return is now in positive territory. Let’s repeat the Senior Citizens Savings Scheme example and see how the real returns stack up.

The interest rate on offer on the Senior Citizens Savings Scheme from April 1, 2016, is 8.6%. For those who do not have to pay any income tax, the real rate of return is 3.4% (8.6% minus 5.2%). For those in the 10%, 20% and 30% tax brackets, the real rate of return works out to 2.54%, 1.68% and 0.82% respectively.

Hence, the situation is substantially better than it was in the past. Investor are actually making a real rate of return on their investments. Also, for savings instrument like PPF, where no tax needs to be paid on accumulated interest, the real returns are higher.

But given that the nominal interest rate has been cut, people have an issue and a lot of noise is being made.

Given these reasons, the government was right in cutting the interest rates on offer on PPF and other small savings schemes. Also, it is important to understand that the high rates of interest on offer on these schemes has been preventing the banks from cutting their deposit as well as lending rates at the speed at which the Reserve Bank of India wants them to.

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 [one basis point is one hundredth of a percentage] has been transmitted by banks. The median base lending rate has declined only by 60 basis points.” Repo rate is the rate at which RBI lends to banks.

While RBI cut the repo rate by 125 basis points in 2015, the banks only managed to pass on less than half of that cut to their end consumers. One reason for this is that many public sector banks have had a huge problem with their corporate loans. Another reason has been the high interest rates on offer on small savings schemes.

The banks compete with these schemes for deposits and given the high interest on offer on post office savings schemes, banks could not cut interest rates beyond a point without losing out on deposits.

The hope now is that the RBI will cut the repo rate further, banks will cut the interest rates on their loans and deposits, and people will borrow and spend. Whether that happens remains to be seen.

(Vivek Kaul is the author of the Easy Money trilogy. He tweets @kaul_vivek)

The column originally appeared on Firstpost on March 19, 2016