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.