RBI

Lower Interest Rates Good for Govt, Banks and Corporates, Not for Average Indian

The new monetary policy committee which met for the first time over the last two days has decided to keep the repo rate unmoved at 4%. Monetary policy committee is a committee which decides on the repo rate of the Reserve Bank of India (RBI). Repo rate is the interest rate at which RBI lends to banks and is expected to set the broad direction for interest rates in the overall economy.

The RBI has been trying to drive down the interest rates in the economy since January 2019. In January 2019, the repo rate was at 6.5%. Since then it has been cut by 250 basis points and is now at 4%. One basis point is one hundredth of a percentage.
This has had some impact in driving down fixed deposit interest rates of banks. Take a look at the following chart.

The Crash


Source: ICICI Securities, October 3, 2020.

From the peak they achieved between March and June 2019, fixed deposit interest rates have fallen by 170 to 220 basis points.
This in an environment where the inflation has been going up. In March 2019, inflation as measured by the consumer price index was at 2.9%. It had jumped slightly to 3.2% by June 2019. In August 2020, the latest data available for inflation as measured by the consumer price index, had jumped to 6.6%. Meanwhile, fixed deposit rates which were around 7-8%, are largely in the range of 4-6% now (of course, there are outliers to this).

Hence, inflation is greater than interest rates on fixed deposits, meaning the purchasing power of the money invested in fixed deposits is actually coming down.

In fact, interest rate on savings bank accounts, which in some cases was as high as 6-7%, has also come down. Take a look at the following chart.

Another crash


Source: ICICI Securities, October 3, 2020.

Savings bank accounts now offer anywhere between 2.5-3%.

The fall in interest rates is not just because of the RBI cutting the repo rate. A bulk of this fall has happened post the covid breakout. Banks haven’t lent money post covid.

Between March 27 and September 25, the outstanding non-food credit of banks has fallen by 1.1% or Rs 1.1 lakh crore to Rs 102 lakh crore. This means that people and firms have been repaying their loans and net-net in the first six months of this financial year, banks haven’t given a single rupee of a fresh loan.

Banks give loans to Food Corporation of India and other state procurement agencies to buy rice and wheat directly from the farmers. Once these loans are subtracted from overall lending by banks, what remains is non-food credit.

During the same period, the deposits of banks have risen by 5.1% or Rs 6.97 lakh crore to Rs 142.6 lakh crore. With people saving more, it clearly shows that the psychology of a recession is in place.

Banks have not been lending while their deposit base has been expanding at a rapid pace. The point being that banks are able to pay an interest on their deposits because they give out loans and charge a higher rate of interest on the loans than they pay on their deposits.

When this mechanism breaks down to some extent, as it has currently, banks need to cut interest rates on their deposits, given that they are not earning much on the newer deposits. This is bound to happen and accordingly, interest rates on fixed deposits have fallen.

While the supply of deposits has gone up, the demand for them in the form of loans, hasn’t. This has led to the price of deposits, which is the interest paid on them, falling.

But there is one more reason why interest rates have fallen. There is excess money floating around in the financial system. The RBI has printed money and pumped it into the financial system by buying bonds from financial institutions.

This excess money has also helped in driving down interest rates. While banks haven’t been able to lend at all in the first six months of the year, the government borrowing has gone through the roof. As the debt manager of the government, the RBI has printed and pumped money into the financial system to drive down the returns on government bond, in the process allowing the government to borrow at lower interest rates. Take a look at the following chart, which plots the returns (or yields) on 10-year bonds of the Indian government.

Going down

Source: Investing.com

The yield on a government bond is the return an investor can earn if he continues to own the bond until maturity. The above chart clearly shows that as the government has borrowed more and more through the year, the interest rate at which it has been able to borrow money has come down, thanks to the RBI and its money printing.

Of course, with banks not lending on the whole, they are happy lending to the government. In fact, in his speech today, the RBI governor Shaktikanta Das said that the central bank planned to print and pump another Rs 1 lakh crore into the financial system in the days to come.

With more money expected to enter the financial system the 10-year government bond yield fell from 6.02% yesterday (October 8) to 5.94% today (October 9), a fall of 8 basis points during the course of the day.

The monetary policy committee also decided to keep the “accommodative stance as long as necessary”, with only one member opposing it. In simple English this means that the RBI will keep driving down interest rates as long as necessary “at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy.”

The assumption here is that as interest rates fall people will borrow and spend more and corporations will borrow and expand more. This will help the economy grow, jobs will be created and incomes will grow. While, this sounds good in theory, it doesn’t really play out exactly like that, at least not in an Indian context.

Let’s take a look at this pointwise.

1) A bulk of deposits in Indian banks are deposited by individuals. In 2017-18, the latest data for which a breakdown is available, individuals held around 55% of deposits in banks by value. This had stood at 45% in 2009-10 and has been constantly rising. Hence, it is safe to say that in 2020-21, the proportion of bank deposits held by individuals will clearly be more than 55%.

When interest rates on deposits (both savings and fixed deposits) go down individuals get hurt the most. There are senior citizens whose regular expenditure is met through interest on these deposits. When a deposit paying 8% matures and has to be reinvested at 5.5%, it creates a problem. Either the family has to cut down on consumption or start spending some of their capital (the money invested in the fixed deposit).

This also disturbs many people who use fixed deposits as a form of long-term saving. The vagaries of the stock market are not meant for everyone. Also, in the last decade returns from investing in stocks haven’t really been great.

2) When interest rates go down, the families referred to above cut down on consumption and do not increase it, as is expected with lower interest rates. This may not sound right to many people who are just used to economists, analysts, bureaucrats, corporates and fund managers, mouthing, lower interest rates leading to an increase in consumption all the time. But there is a significant section of people whose consumption does get hurt by lower interest rates.

3) It’s not just about bank interest rates going down. Returns on provident fund/pension funds which hold government bonds for long time periods until maturity and post office schemes (despite being higher than banks), also come down in the process.

4) Also, no corporate is going to invest just because interest rates are low right now. Corporates invest and expand when they see a future consumption potential. This is currently missing. Also, banks lending to industry peaked at 22.43% of the GDP in 2012-13. It fell to 14.28% of the GDP in 2019-20. During the period, interest rates have gone up and down, but corporate lending as a proportion of the GDP has continued to fall. So clearly increased borrowing by corporates is not just about interest rates.

But corporates love to constantly talk about high interest rates as a reason not to invest. This is just a way of driving down interest on their current debt.

As former RBI governor Urjit Patel writes in Overdraft:

“Sowing disorder by confusing issues is a tried-and-trusted, distressingly often successful routine by which stakeholders, official and private, plant the seeds of policy/regulation reversal in India.”

One can understand interest rates going down in an environment like the current one, but there is a flip side to it as well, which one doesn’t hear the experts talk about at all. Also, anyone has barely mentioned the excess liquidity in the financial system, which currently stands at Rs 3.9 lakh crore. Why is that? Let’s look at this pointwise.

1)  The equity fund managers love it because with interest rates going down further, many investors will end up investing money in stocks despite very high price to earnings ratio that currently prevails. The price to earnings ratio of the Nifty 50 index currently is at 34.7. This is a kind of level that has never been seen before.

But with post tax real returns from fixed deposits (after adjusting for inflation) in negative territory, many investors continue to bet on stocks, despite the lack of earnings growth.

2) The debt fund managers love it because interest rates and bond prices are negatively related. When interest rates come down, bond yields come down and this leads to bond prices going up. This means that the debt funds managed by these fund managers see capital gains and their overall returns go up. Hence, debt fund managers love lower interest rates.

3) Banks invest a large proportion of the deposits they gather into government bonds. When bond yields fall, bond prices go up. This leads to a higher profit for banks. This in an environment where banks aren’t lending. Hence, bankers love lower interest rates.

4) Corporates love lower interest rates at all points of time, irrespective of whether they want to borrow or not. I don’t think this needs to be explained.

5) The government loves low interest rates because it can borrow at lower rates. Second, with the stock market going up, it can sell a positive narrative. If the economy is doing so badly, why is the stock market doing well?

6) This leaves economists. Economists love lower interest rates because the textbooks they read, said so.

The question is do lower interest rates or interest rates make a difference when it comes to borrowing by an average Indian? Let’s take a look at non-housing retail borrowing from banks over the years. In 2007-08 it stood at 5.34% of the gross domestic product (GDP). In 2019-2020, it stood at an all-time high of 5.97% of GDP.

In a period of 12 years, non-housing retail borrowing from banks, has barely moved. What it tells us to some extent is that the idea of taking on a loan to buy something (other than a house), is still alien to many Indians.

So, the idea that interest rates falling leading to increased retail borrowing is a little shaky in the Indian context.

To conclude, today the RBI governor Shaktikanta Das gave a speech which was more than 4,000 words long. In this speech, the phrase fixed deposit interest rate did not appear even once.

A whole generation of savers is getting screwed (for the lack of a better word) and the RBI Governor doesn’t even bother mentioning it in his speech. The RBI seems to be constantly worried about the interest rate at which the government borrows.

A central bank which only bats for the government, corporates and bond market investors, is always and anywhere a bad idea.

Shaktikanta Das’ RBI is at the top of this bad idea.

 

Interest on Interest Case Can Open a Pandora’s Box. Govt and SC Need to Be Careful

Late last week the central government told the Supreme Court that it was ready to waive off the interest on interest (i.e. compound interest) on loans of up to Rs 2 crore during the moratorium period of six months between March and August 2020.

In an affidavit submitted to the Court, the government said: “The government… has decided that the relief on waiver of compound interest [interest on interest] during the six month moratorium period shall be limited to the most vulnerable category of borrowers. This category of borrowers, in whose case, the compounding of interest will be waived, will be MSME loans and personal loans up to Rs 2 crore.”

This response was as a part of the matter of Gajendra Sharma versus the Union of India.

The Reserve Bank of India refers to retail loans as personal loans. Hence, the types of loans which would get a waiver of compound interest for a period of six months of the moratorium are home loans, vehicle loans, education loans, consumer durables loans, credit card outstandings, normal personal loans and MSME loans. This benefit will be available to all borrowers who have taken loans of up to Rs 2 crore, irrespective of whether they opted for the moratorium or not.

Before offering my views on this, let’s first try and understand the concept of compound interest or interest on interest.

Let’s consider a home loan of Rs 2 crore to be repaid over a period of 20 years (or 240 months) at the rate of 8% per year. Let’s further assume that the loan was taken during the month of March and was immediately put under a moratorium (the need to make this assumption will soon become clear).

The moratorium lasted six months. The simple interest on the loan of Rs 2 crore amounts to Rs 8 lakh (8% of Rs 2 crore divided by 2). This is not how banks operate. They calculate interest on a monthly basis. At 8% per year, the monthly interest works out to 0.67% (8% divided by 12). The interest for the first month works out to Rs 1.33 lakh (0.67% of Rs 2 crore).

Since the loan is under a moratorium and is not being repaid, this interest is added to the loan amount outstanding of Rs 2 crore.
Hence, the loan amount outstanding at the end of the first month is Rs 2.013 crore (Rs 2 crore + Rs 1.33 lakh). In the second month, the interest is calculated on this amount and it works out to Rs 1.34 lakh (0.67% of Rs 2.013 crore).

In this case, we calculate interest on the original outstanding amount of Rs 2 crore. We also calculate the interest on Rs 1.33 lakh, the interest outstanding at the point of the first month, which has become a part of the loan outstanding.

At the end of the second month, the loan amount outstanding is Rs 2.027 crore (Rs 2.013 crore + Rs 1.34 lakh).  This happens every month, over the period of six months, as can be seen in the following table.

Interest on interest

 

Source: Author calculations.

At the end of six months, we end up with a loan outstanding of Rs 2.081 crore. This is Rs 8.134 lakh more than the initial loan outstanding of Rs 2 crore. As mentioned initially, the simple interest on Rs 2 crore at 8% for a period of six months works out to Rs 8 lakh.

Hence, the interest on interest works out to Rs 13,452 (Rs 8.134 lakh minus Rs 8 lakh).

What was the point behind doing all this math and trying to explain compound interest here?

The maximum amount on which the government is ready to waive off interest on interest is Rs 2 crore. For the kinds of loan under consideration Rs 2 crore outstanding is likely to be either on a home loan or a SME loan. In case of an SME loan, the interest rate will probably be more than 8%.

On a home loan of Rs 2 crore at 8% with 240 instalments (20 years) left to pay, the interest on interest for a period of six months works out close to Rs 13,500. The point is if an individual can afford to take on a loan of Rs 2 crore at 8% interest and pay an EMI of Rs 1.67 lakh, he can also pay an interest on interest of Rs 13,452. In case of an SME loan, the interest on interest would be higher than Rs 13,432, but it wouldn’t be an unaffordable amount. So, what’s the point of doing this?

An estimate made by Kotak Institutional Equities suggests that this move is likely to cost the government around Rs 8,000 crore (Rs 5,000 crore for banks + Rs 3,000 crore for non-banking finance companies (NBFCs)). While Rs 8,000 crore isn’t exactly small change but it’s not a very large amount for the central government.

But that’s not the point here. This move and the Supreme Court dabbling in this case will end up opening a pandora’s box. Let’s take a look at this pointwise.

1) Media reports suggest that the Supreme Court is not happy with the government’s offer to waive off interest on interest. A report on NDTV.com suggests that waiving interest on interest on loans of up to Rs 2 crore “was not satisfactory and asked for a do-over in a week”.

As the report points out: “The affidavit “fails to deal with several issues raised by petitioners”, the court said. The central government has been asked to consider the concerns of the real estate and power producers in fresh affidavits.” Clearly, neither the Court nor the companies are happy with interest on interest of loans of up to Rs 2 crore being waived off.
By offering to waive off interest on interest the government is trying to meet the Court halfway. Also, it is important that the Court along with the government realise that they are interfering with the process of interest setting by banks, something that largely works well.

What is interest at the end of the day? Interest is the price of money. By taking on this case, the Supreme Court has essentially gotten into deciding the price of money. When a bank pays an interest to a deposit holder, it 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 process works.

The government and the Court are both trying to fiddle around with the price of money and that is not a good thing. Today one set of companies have approached the Court to decide on the price of money, tomorrow another set might do the same.

2) The companies are clearly not happy with the interest on interest waiver offer primarily because their loans are greater than Rs 2 crore and they want more. This is hardly surprising.

In the affidavit the government has said: “If the government were to consider waiving interest on all the loan and advances to all classes and categories of borrowers corresponding to the six-month period for which the moratorium was made available under the relevant RBI circulars, the estimated amount is Rs 6 lakh crore.”

To this, the response of the real estate lobby CREDAI was: “A lot of facts and figures in the government’s affidavit are without any basis and the finance ministry’s estimate that waiving off interest on loans to every category would cost banks Rs 6 lakh crore is wrong.”

It is easy to verify this with a simple back of the envelope calculation. As of March 2020, the non-food credit of banks was at Rs 103.2 lakh crore. The banks give loans to Food Corporation of India and other state procurement agencies to buy rice and wheat directly from farmers. Once these loans are subtracted from the overall loans of banks, what is left is non-food credit.

The weighted average lending rate of scheduled commercial banks was at 10% in March 2020 (This is publicly available data). Just the simple interest on non-food credit for six months works out to Rs 5.16 lakh crore (10% of Rs 103.2 lakh crore divided by 2).

Over and above this, there is lending carried out by NBFCs, on which interest on interest will have to be waived off as well. Also, once we take compound interest into account, Rs 6 lakh crore is clearly not a wrong figure as CREDAI wants us to believe.

The weighted average lending interest rate has fallen a little since March. In August, the weighted average lending rate of scheduled commercial banks was at 9.65%. Even after taking this into account, Rs 6 lakh crore is not an unrealistic number at all.  The government and the SC need to be careful regarding any demands of lowering interest rates on loans.

3) The real estate companies have an incentive in getting as much from the Court as possible. Financially, many of them are overleveraged. In fact, the former RBI Governor Urjit Patel in his book Overdraft refers to them as ‘living dead’ borrowers or zombies. And a living dead borrower will go as far as possible to survive at the cost of others. Any new bailout allows them to survive in order to die another day. Also, it allows them to continue not cutting home prices.

Clearly, companies want some reworking on the interest front (the interest on interest for a period of six months isn’t going to amount to much). But this raises a few fundamental questions.

If the Court and the government get around to cutting interest rates on loans, they will be deciding on the price of money. If they do it this one time, they are basically giving Indian capitalists the idea that they can approach the courts and challenge the price of money being charged. What stops it from happening over and over again?

While the government does try and influence the interest rates charged on loans by public sector banks, it can’t do so when it comes to private banks, which now form around 35% of the market when it comes to loans. Nevertheless, if any decision lowering interest rates is made they will end up influencing the price of money of private banks as well. And that isn’t a good thing. The last thing you want in a period of economic contraction is to try and disturb the banking system in any way.

4) Also, any interest rate waiver or reduction will give political parties ideas, like waiving off agricultural loans they can waive off other loans as well. And that can’t be a good thing for the stability of the Indian banking system.

5) If the government really wants to help businesses it can do so by reforming the goods and services tax and making it more user friendly. That will go a much longer way in helping the Indian economy without disturbing a process which currently works well. Any fiddling around with interest rates is largely going to help only zombie companies.

As Urjit Patel writes in Overdraft: “Sowing disorder by confusing issues is a tried-and-trusted, distressingly often successful routine by which stakeholders, official and private, plant the seeds of policy/regulation reversal in India.” This time is no different. Hence, both the government and the Supreme Court need to be very careful in how they deal with this. It is ultimately, the hard earned money of millions of Indians which is at stake. The Indian banking system is one of the few systems which people continue to trust. You wouldn’t want that to break down.

 

Has RBI Lost Control of Monetary Policy?

On August 31, 2020, the Reserve Bank of India (RBI), published an innocuously titled press release RBI Announces Measures to Foster Orderly Market Conditions. The third paragraph and the fourth line of the release said this: “The recent appreciation of the rupee is working towards containing imported inflationary pressures [emphasis added].”

What did this line mean? Take a look at the following chart. As of June 18, one dollar was worth Rs 76.55. By August 31, one dollar was worth Rs 73.13. The rupee had gained value or appreciated against the dollar.


Rupee Up, Dollar Down

 
Source: Yahoo Finance.

What has this got to do with inflation? When the value of the rupee appreciates against the dollar, the imports become cheaper.

Let’s say the price of a product being imported into India is $10. If the dollar is worth Rs 76, it costs Rs 760. If the dollar is worth Rs 73, it costs Rs 730. Hence, if the rupee appreciates, imports become cheaper and in the process the inflation (or the rate of price rise) that we import from abroad, comes down as well.

The trouble is that if imports become cheaper, things become difficult for the home-grown products. Hence, an appreciating rupee goes against the government’s pet idea of atmanirbhartha or producing goods locally.

Given that the current dispensation at the RBI is more or less in line with what the government wants, this move to allow the rupee to appreciate, so that it reduces imported inflation, is even more surprising. (On a different note, I am all for consumers getting to buy things cheaper than in the past. The point of all economic activity, at the end of the day, is consumption. But most people don’t think like that).

Also, RBI’s Monetary Policy Report released in April, suggests that the impact of the appreciation of rupee on inflation is at best marginal: “An appreciation of the Indian Rupee by 5 per cent could moderate inflation by around 20 basis points.” One basis point is one hundredth of a percentage.

The trilemma

So what’s happening here? The RBI has basically hit the trilemma, something which it can’t admit to. Trilemma is a concept which was originally expounded by the Canadian economist Robert Mundell. Basically, a central bank cannot have free international movement of capital, a fixed exchange rate and an independent monetary policy, all at the same time. It can only choose two out of these three objectives. Monetary policy refers to the process of setting of interest rates in an economy, carried out by the central bank of the country.

Of course, this is economic theory and in practice things are slightly different. The more a central bank allows free international movement of capital (i.e. money) and has a tendency to continuously intervene in the foreign exchange market and not allow free movement in the price of the local currency against the dollar, the lesser control it has over its monetary policy.

Let’s try and understand this through an example. Let’s consider the central bank of a country which allows for a reasonable movement of capital. At the same time, it wants to ensure that the value of its currency against the US dollar doesn’t move much.

This is to ensure that its exporters don’t face much volatility on the exchange rate front. Over and above this, the central bank does not want its currency to appreciate because that would hurt the exporters and make them less competitive.

In this scenario, let’s say the central bank sets interest rates at a higher rate than the rates in the United States and other parts of the world. What will happen is given that reasonably free movement of capital is allowed money from other parts of the world will come flooding in to cash in on the higher interest.

When the foreign capital comes into the country in the form of dollars and other currencies, it will have to be converted into the local currency. This will lead to the demand of the local currency going up and the local currency will appreciate against the dollar. Of course, when this happens, the value of the local currency will no longer remain fixed against the US dollar.

This is where the trilemma comes to the fore. If the country wants monetary independence and free movement of capital, it cannot have a fixed exchange rate. If it wants a fixed exchange rate then it has to set interest rates around the interest rate set by the Federal Reserve, so that it doesn’t attract capital because of a higher interest rate. In the process, it loses control of monetary policy.

In the Indian case, in the recent past, the RBI has tried to pursue all the three objectives, reasonably free movement of capital, a currency (the rupee) which doesn’t appreciate against the dollar and an independent monetary policy.

The repo rate, or the rate at which the RBI lends to banks, was cut from 5.15% to 4%, in the aftermath of the covid-pandemic. The RBI has also flooded the financial system with money by buying government bonds.

Between February 24 and April 23, the RBI lent a lot of money to banks through long-term repo operations, targeted long-term repo operations and targeted long-term repo operations 2.0. These schemes have essentially lent money to banks at the repo rate for the long term. On February 24, the RBI lent Rs 25,021 crore to banks for a period of 365 days at the prevailing repo rate of 5.15%. The repo rate is the interest at which RBI lends to banks, typically for the short-term.

After this, the RBI has lent around Rs 2.13 lakh crore for a period of around three years at the prevailing repo rate. Around Rs 1 lakh crore out of this was lent at 5.15%. In late March, the RBI cut the repo rate by 75 basis points to 4.4%. The remaining Rs 1.13 lakh crore has been lent at this rate. The idea here was to encourage to lend money to banks at a low interest rate and then encourage them to lend further, under certain conditions. There has been more bond buying over and above this.

The idea was to drive down interest rates to lower levels, so that companies borrow and expand, people borrow and consume. In the process, the economy starts to recover. Also, with the government borrowing more this year, lower interest rates would help it as well.

Along with this, the reasonably free movement of capital that India allows has continued. The RBI has also intervened in the currency markets trying to ensure that the rupee doesn’t appreciate against the dollar.

What’s happening here? In the aftermath of covid, Western central banks have gone on a money printing spree, some to drive down interest rates and to get businesses to expand and people to consume, and some others to finance the expenditure of their government. Take the case of the Federal Reserve of the United States. Between February end and early June, it printed a close to $3 trillion and expanded its balance sheet by three-fourths in the process.

To cut a long story short, interest rates have been driven down globally and there is a lot of money going around looking for some extra return. Some of this money has been coming to the Indian stock market.

In 2020-21, the current financial year, the foreign institutional investors (FIIs) have net invested $7.62 billion in the Indian stock and bond market. A good amount of this, $6.66 billion, came in August, when FII investment turned into a deluge. Of course, there were months like April and May, when the FIIs net sold. Between June and August, the FIIs net invested $10.54 billion in the Indian stock and bond markets.

The foreign direct investment (FDI) coming into India between April and July stood at $5.86 billion, with $4.01 billion coming just in July. The outward FDI (Indians investing abroad) in the first four months, stood at $3.17 billion. This means that the net FDI number (foreign investments made by Indians deducted from investments in India by foreigners) has been in positive territory. Net-net dollars have come into India on the FDI front.

Over and above this, the net receipts from services (i.e. services exports minus services imports) stood at around $28 billion between April and July.

Other than this, the demand for dollars, from within India, has come down. The import of crude oil and petroleum products between April and August 2020 has fallen by 53.7% to $26.02 billion. This has been both on account of fall in price of oil as well as lower consumption. In fact, on the whole, the goods exports have fallen at a lesser pace than goods imports, again implying a reduced demand for dollars within India.

Internal remittances, the money sent by Indians working abroad back to India, must have definitely fallen this year (I say must because the data for this isn’t currently available). Nevertheless, at the same time, outward remittances, everything from money spent on health, education and travel, has also come down, given that barely anyone is travelling abroad.

What does this basically mean? It means more dollars are coming into India than leaving India. When dollars come into India they need to be converted into rupees. This increases the demand for rupees and the rupee then appreciates against the dollar. This, as I have explained above, hurts atmanirbharta, domestic producers of goods and exporters, all at once.

Preventing the appreciation of the rupee

To prevent the rupee from appreciating against the dollar, the RBI buys dollars by selling rupees. In fact, that is precisely what the RBI has done between April and July this year. It has net purchased $29 billion, the highest in this period in the last five years. The August press release suggests that the RBI stopped trying to defend the rupee from appreciating sometime during the month or at least didn’t try as hard as it did in the past.

If we look at the foreign currency assets of the RBI they have barely moved between August 28 (three days before the press release) and September 18 (the latest data available), barely increasing from $498.36 billion to $501.46 billion. This tells us that the RBI isn’t really intervening much in the foreign exchange market in the recent past. But that might also be because of the fact that in September (up to September 29), the FIIs have net sold stocks and bonds worth just $4 million. Net net, FIIs didn’t bring any dollars into India in September.

By buying dollars, the RBI releases rupees into the Indian financial system and thus increases the money supply. In the normal scheme of things, the RBI can sterilise this by selling bonds and sucking out this money. But that would have gone against the easy money policy that the Indian central bank has been running through this financial year.

The excess liquidity (or the money that the banks deposit with the RBI) in the financial system suggests that the RBI hasn’t really been sterilising the rupees it has put into the system to prevent the appreciation of the rupee. On the whole, the bond buying by the RBI in order to release money into the financial system, has been in the positive territory. The following chart plots this excess liquidity in the system.

Easy Money


Source: Centre for Monitoring Indian Economy.

 

The excess liquidity in the system, money which banks had no use for and parked with the RBI, even crossed Rs 6 lakh crore in early May. It has since fallen but is still at a very high Rs 2.72 lakh crore.

So, what does all this mean?

The inflation between April and August, as measured by the consumer price index, has been at 6.63%. The inflation in August was at 6.69%. As per the RBI’s agreement with the government the inflation should be 4% within a band of +/- 2%.

This means that the current inflation is way beyond range. A major reason for this is high food inflation which between April and August has been at 9.58%. The food inflation in August was at 9.05%.

If we look at the core inflation (which leaves out food, fuel and light), it is at 5.16%. If we add fuel inflation to this (thanks to the government increasing the excise duty on petrol and diesel), the inflation is higher.

Where does this leave the RBI? All the liquidity in the financial system hasn’t led to even higher inflation primarily because there has been an economic collapse and people are not spending money as fast as they were in the past.

Food inflation has primarily been on account of supply chains breaking down thanks to the spread of the covid-pandemic. The trouble is that covid is now spreading across rural India. As Crisil Research put it in a recent report: “Of all the districts with 1,000+ cases, almost half were rural as on August 31, up from 20% in June.” This basically means that the supply chain issues when it comes to movement of food are likely to stay, during the second half of the year as well.

Food on its own makes up for 39.06% of the overall index and 47.25% of the index in rural India. As the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework (better known as the Urjit Patel Committee) said:

“High inflation in food and energy items is generally reflected in elevated inflation expectations. With a lag, this gets manifested in the inflation of other items, particularly services. Shocks to food inflation and fuel inflation also have a much larger and more persistent impact on inflation expectations than shocks to non-food non-fuel inflation.”

An IMF Working Paper titled Food Inflation in India: The Role for Monetary Policy suggests the same thing: “Food inflation [feeds] quickly into wages and core inflation.” This is something that the country saw in the five-year period before 2014, when food inflation seeped into overall inflation.

What this means is that if covid continues to spread through rural India and food supply chains continue to remain broken, food inflation will persist and this will seep through into overall inflation, which is anyway on the high side.

In this situation what will the RBI do in the months to come? As mentioned earlier, all the money that the RBI has pumped into the Indian financial system hasn’t led to an even higher inflation simply because the consumer demand has collapsed. But as the economy continues to open up and the demand picks up, there is bound to be some amount of excess money chasing the same amount of goods and services, leading to higher inflation.

In this scenario what will the RBI do to prevent the appreciation of the rupee against the dollar, especially if foreign capital continues to come to India and the demand for the rupee continues to remain high?

As mentioned earlier, if the RBI buys dollars and sells rupees to prevent appreciation, it will continue to add to money supply. Interestingly, the money supply (as measured by M3 or broad money) has been growing at a pace greater than 12% (year on year) since June. This kind of rise in money supply was previously seen only before 2014, a high inflation era.

If RBI keeps trying to intervene in the foreign exchange market to prevent the appreciation of the rupee against the dollar, it will keep adding to the money supply and that creates the risk of even higher inflation. To counter this risk of higher inflation, the RBI will need to raise the repo rate or the interest rate at which it lends to banks.

This goes against what the Indian economy or for that matter any economy, needs, when it is going through an economic contraction. This in a way suggests that the RBI has lost control over the monetary policy. In fact, even if the monetary policy committee (MPC) of the RBI, whenever it meets next, keeps the repo rate constant, it suggests a lack of control over monetary policy. This also explains why the RBI hasn’t made any inflation projections since February this year.

Of course, the RBI has the option of sterilising the extra rupees it releases into the financial system by buying dollars coming into India. In order to sterilise the extra rupees being released into the financial system, the RBI needs to sell government bonds. The RBI needs to pay a certain rate of interest on these bonds. These bonds are a liability for the RBI.

As far as assets of the RBI go, a significant portion is invested in bonds issued by the American and other Western governments and the International Monetary Fund. These assets pay a much lower rate of interest than the interest that the RBI needs to pay on bonds it sells to sterilise excess rupees in the financial system. This is referred to as the quasi fiscal cost and needs to be kept in mind.

The second problem with sterilisation is that it might lead to a situation where interest rates might go up, creating further problems. As an RBI research paper titled Forex Market Operations and Liquidity Management published in August 2018 points out:

“For example, when a central bank undertakes open market sale of government securities to absorb the surplus liquidity as a part of the sterilised intervention strategy, it could harden sovereign yields, which, in turn, could attract further debt inflows driven by higher interest rate differentials.”

What does this mean in simple English? When the RBI sells government bonds to carry out sterilisation, it sucks out excess rupees from the market. This might lead to interest rates going up. If interest rates go up more foreign money will come into India looking to earn that higher interest rate. And this will create the same problem all over again, with the demand for rupee going up and the RBI having to intervene in the foreign exchange market.

Any increase in interest rates will not go down well with the government which will end up borrowing a lot of money this year, thanks to a collapse in tax revenues. Take a look at the following chart which plots the 10-year government bond yield from the beginning of 2020. The 10-year government bond-yield is the return an investor can expect per year, if they continue owning the bond until maturity.

Down and then slightly up

Source: https://in.investing.com/rates-bonds/india-10-year-bond-yield-historical-data

Thanks to all the easy money created by the RBI there has been excess money in the Indian financial system, since the beginning of this year. This has helped drive down bond yields from around 6.5% at the beginning of the year to a low of 5.76% in July and to around 6.04% currently. Hence, the Indian government has been able to borrow at a lower rate thanks to the excess liquidity created by the RBI and it wouldn’t want that to change. Also, the yields have been rising gradually since July, making sterilising even more difficult.

If the RBI keeps intervening it creates the risk of increasing money supply and that leading to the risk of even higher inflation. A high inflation in a poor country is never a good idea. If the RBI does not intervene that leads to the rupee appreciating and in the process creating problems for the domestic industry as well as the atmabnirbhar strategy. The exporters suffer as well.

What’s the RBI’s best strategy here? It can pray that foreign inflows slow down for a while, like they have in September. But that was basically the FIIs reacting to the Indian economy contracting by nearly a fourth between April to June. This data point was published on August 31. Also, as the economy keeps opening up more and more, imports and other spending pick up, the demand for the dollar will go up as well. All this will help the RBI. Nevertheless, if Western central banks unleash even more money printing, then all this will go for a toss.

The RBI ended up in this position by abandoning its main goal of managing price inflation. The agreement between the government and the RBI states clearly that “the objective of monetary policy is to primarily maintain price stability [emphasis added], while keeping in mind the objective of growth.”

Instead of managing inflation, the RBI chose its role as the debt manager of the government to outshine everything. This led to all the excess liquidity in the system so that interest rates were driven down and the government could borrow at lower interest rates. The Times of India reports on October 1, 2020: “The weighted cost of borrowing [for the government] during the first half was 5.8%, the lowest in 15 years.”

While the government has borrowed more, the overall non-food credit given by banks has shrunk between March 27 and September 11, from Rs 103.2 lakh crore to Rs 101.6 lakh crore. The banks lend money to the Food Corporation of India and other state procurement agencies to primarily buy rice and wheat (and some oilseeds and pulses in the recent past) directly from the farmers. Once this credit is subtracted from overall credit of banks what remains is non-food credit.

What this tells us is that despite lower interest rates overall lending by banks has shrunk. This might primarily be because of people and firms prepaying loans as well as a general slowdown in loan disbursal. Of course, the fall in interest rates has hurt savers and nobody seems to be talking about them.

To conclude, the RBI abandoned its main goal and is now stuck because of that. As economists Raghuram Rajan and Eswar Prasad wrote in a 2008 article : “The central bank is also held responsible, in political and public circles, for a stable exchange rate. The RBI has gamely taken on this additional objective but with essentially one instrument, the interest rate, at its disposal, it performs a high-wire balancing act.”

By trying to do too many things at the same time, RBI ends up being neither here nor there. As Rajan and Prasad put it: “What is wrong with this? Simple that by trying to do too many things at once, the RBI risks doing none of them well.” This was a mistake the RBI used to make pre-2015, before the agreement with the government was signed. It has gone back to making the same mistake again.

As Rajan wrote in the 2008 Report of the Committee on Financial Sector Reforms: “The Reserve Bank of India (RBI) can best serve the cause of growth by focusing on controlling inflation.”

But that’s not to be, given that politicians, bureaucrats and even economists, expect monetary policy to perform miracles it really can’t.

I would like to thank Chintan Patel for research assistance. 

 

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.

An Appreciating Rupee and Atmnirbharta Don’t Go Together

One dollar was worth around Rs 77.6 in mid-April. Since then, the rupee has appreciated against the dollar and now one dollar is worth around Rs 73.5.

In a press release on August 31, the Reserve Bank of India (RBI) explained the mystery of the appreciating rupee by saying: “the recent appreciation of the rupee is working towards containing imported inflationary pressures.”

Before analysing this statement, it is important to understand what it means. India’s imports are consumption oriented and not capital goods oriented. This can be gauged from the fact that non-oil, non-gold and non-silver imports, a very good indicator of consumer demand, moved from 55.8% of the total imports in 2011-12 to 69.7% in 2016-17. In 2019-20, these imports at 65.9% of total imports.

What this also tells us is that Indians prefer to buy imported goods than what is produced in India, wherever there was a choice. Their revealed preference is very clear on this front.

In this scenario, when the rupee appreciates against the dollar, the cost of imports comes down. Let’s say a product is imported for $10. At one dollar being worth Rs 77.6, it costs Rs 776. At one dollar being worth Rs 73.5, it costs Rs 735. There is a clear fall in price as the rupee appreciates. This helps control inflation or the overall rate of price rise.

As the RBI pointed out in its monetary policy report released in April earlier this year: “An appreciation of the INR by 5 per cent could moderate inflation by around 20 basis points.” One basis point is one-hundredth of a percentage.

An appreciating rupee is basically an indicator of excessive dollar inflows into India. When these dollars come into India, they need to be converted into rupees. This pushes up the demand for rupees, leading to the rupee appreciating.

One way of preventing this is the RBI buying the dollars that are coming in by selling rupees, in order to ensure that there are enough rupees in the system and in the process, the rupee doesn’t appreciate against the dollar or at least appreciates at a gradual pace. The RBI is not doing this or to put it more specifically isn’t doing as much of this as it was in the past.

This, as the RBI has explained is being done to control imported inflation.

The inflation as measured by the consumer price index, between April and July this year, was at 6.7%. Core inflation which ignores food, fuel and light items, was at 5.1%, with non-core inflation being at 8.6%. The high non-core inflation was on account of food inflation being at 9.8% between April and July. RBI has no control over food inflation.

Also, food inflation has been primarily on account of supply chains breaking down on account of the spread of the covid-pandemic. So, is the RBI getting too desperate, is a question well-worth asking here.

An appreciating rupee benefits imports and importers. This in a scenario where the government of the day has been talking about India becoming atmnirbhar or promoting self-reliance. In order to promote this, higher-tariffs on imports, like a higher customs duty on specific-imports, has been the way to go.

As the late Arun Jaitely said in the 2018-19 budget speech: “In this budget, I am making a calibrated departure from the underlying policy in the last two decades, wherein the trend largely was to reduce the customs duty.” This has been the policy stance of the government over the last few years.

But all this gets undone if the rupee is allowed to appreciate against the dollar. It makes imports cheaper and domestic producers will find it even more difficult to compete against the imports. Hence, this goes against the entire idea of atmnirbharta or encouraging domestic producers. It also goes against the idea of getting foreign companies to produce within India. If the rupee keeps appreciating they might just like the idea of importing most of the inputs and then assembling the end product in India.

This is quite weird, given that since Shaktikanta Das took over as the governor of the RBI, India’s central bank has more or less acted on the instructions of the government, rarely having a mind of its own. That makes me wonder what is really happening here?

Having said that, this is good news for the Indian consumer. As David Boaz writes in The Libertarian Mind: “The point of economic activity is consumption. We produce in order to consume… For each participant in international trade, the goal is to acquire consumption goods as cheaply as possible.”

So, is the RBI really batting for the Indian consumer in the aftermath of the economy being hit by the covid-pandemic? Or is there something more to the entire thing? On that your guess is as good as mine.