EMIs down by Rs 20 per lakh, we will all buy cars now

 

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The Nobel Prize winning physicist Albert Einstein once said: “It can scarcely be denied that the supreme goal of all theory is to make the irreducible basic elements as simple and as few as possible without having to surrender the adequate representation of a single datum of experience.”

This line is believed to be the source of another quote that often gets attributed to Einstein: “Everything should be made as simple as possible, but no simpler.” Irrespective of whether Einstein said this or not, it remains a very powerful quote.

It is typically applicable in scenarios where we are trying to explain things to people. And in our zeal to explain things we end up making things much simpler than they actually are. Now take the case of the Reserve Bank of India’s decision to cut the repo rate by 50 basis points (one basis point is one hundredth of a percentage) to 6.75%, yesterday. 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.

This immediately led many analysts and experts who appear on television to conclude that EMIs will now fall and hence, people will borrow more and buy cars, bikes, homes, and so on. This simplistic sort of analysis you would have read by now in your daily newspaper as well.

Only if it was as simple as that.

The banks borrow deposits at a certain rate of interest. They lend these deposits as loans at a higher rate of interest. Hence, for banks to cut the interest rates at which they lend, they first need to cut interest rates at which they borrow.

Further, even if banks cut deposit rates, after a cut in the repo rate, they may not cut lending rates or they may not cut lending rates to the same extent as the deposit rates. As the RBI said in a statement released yesterday: “The median base lending rates of banks have fallen by only about 30 basis points despite extremely easy liquidity conditions. This is a fraction of the 75 basis points of the policy rate reduction during January-June, even after a passage of eight months since the first rate action by the Reserve Bank. Bank deposit rates have, however, been reduced significantly, suggesting that further transmission is possible.”

Before yesterday’s 50 basis points cut in the repo rate, the RBI had cut the repo rate by 75 basis points between January and June 2015. In response to this banks had cut their lending rates by around 30 basis points on an average. They had cut their deposit rates more.

Why was this the case? In some cases, banks were simply trying to make more money. In other cases, particularly in case of public sector banks, the banks also had to deal with a huge amount of bad loans that had been piling up. Basically banks had lent money to corporates, who were no longer returning it. In this scenario, in order to maintain their profit levels, banks decided to cut their deposit rates more than their lending rates.

Further, banks also need to compete with small savings schemes offered by India Post. Hence, they cannot cut interest rates on their deposits beyond a point, unless the interest rates offered on the small savings schemes are cut as well.

The larger point being the “transmission” as experts like to call it from a repo rate cut to falling interest rates on banks loans, is not so straightforward, as it is often made out to be.

In the press conference that happened soon after the RBI rate cut, the economic affairs secretary Shaktikanta Das said that the government would review the interest rate offered on small savings schemes like the Public Provident Fund (PPF) and post office deposits.

Soon after this, the State Bank of India cut its base rate by 40 basis points to 9.3%. The cut will be effective from October 5, 2015. Base rate is the minimum interest rate a bank charges its customers. This cut by the country’s largest bank is expected to force the big private sector banks to act as well and cut their base rates. Andhra Bank also cut its base rate by 25 basis points to 9.7%.

Hence, this time the transmission of lower interest rates after a repo rate cut is likely to be faster than in the past. Nevertheless, does that mean consumption will pick up because interest rates are now slightly lower?

Let’s do some basic maths to understand this. SBI currently offers a car loan at 10.05% to men, 35 basis points above its base rate of 9.7%. For women, the rate of interest charged is 10%.

A car loan of five years of Rs 5 lakh at 10.05% would mean paying an EMI of Rs 10,636 in order to repay the loan. With the base rate being cut by 40 basis points, a new car loan would be offered at an interest of 9.65%. This would mean an EMI of Rs 10,538 or around Rs 100 lower. Hence, for every Rs 1 lakh of loan, the EMI will come down by around Rs 20 (Rs 100 divided by 5).

So, does that mean people will now buy cars because the car loan EMI will be down Rs 20 per lakh? Does that also mean that people were earlier not buying cars because the car loan EMI was Rs 20 per lakh higher?

If the car industry is to be believed that seems to be the case. Rakesh Srivastava of Hyundai Motors told the news-agency PTI that the rate cut was a “festival gift” from the RBI. R S Kalsi of Maruti Suzuki said: “On the whole, it gives a good signal to customers. The market so far has been moving very slowly but with this (rate cut) sentiments will improve. It gives the much-needed boost to the market in the pre-festive season.”

In fact, Pawan Munjal of Hero Honda also joined the rate-cut kirtan and said: “It has come at an opportune time as it will help in raising customer sentiment during the festival season.”

Hero Honda as you would know is in the business of selling two-wheelers, motorcycles in particular. SBI currently charges 12.85% on its Superbike loan. The EMI on a Rs 50,000, three year loan, would work out to Rs 1681.1. With a 40 basis points cut, the new interest rate will be 12.45%. The EMI on this will be around Rs 1671.5, or around Rs 10 lower.

So people will go and buy bikes because the EMI is Rs 10 lower now? And they were not buying bikes earlier because the EMI was Rs 10 too high?

This sort of simplistic logic on part of corporates and analysis on part of the media, really beats me.

People will consume and buy things when they feel confident about their economic future. This will happen when they see job security and steady increments on the way. Steady increments will come when corporate profits start growing, which isn’t the case currently. Corporate profits will start growing when the corporates are able to clean up the excessive debt that they have on their balance sheets now, among other things. And all this is easier said than done.

At the end of the day, monetary policy can only do so much.

Postscript: I would also suggest that you read an excellent piece by Tanushree Banerjee, Co-Head of Research at Equitymaster, on yesterday’s rate cut. You can read the piece here

The column originally appeared on The Daily Reckoning on Sep 30, 2015

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About vivekkaul
Vivek Kaul is a writer who has worked at senior positions with the Daily News and Analysis(DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System , the latest book in the trilogy has just been published. The first two books in the trilogy were published in November 2013 and July 2014 respectively. Both the books were bestsellers on Amazon.com and Amazon.in. Currently he works as an economic commentator and writes regular columns for www.firstpost.com. He is also the India editor of The Daily Reckoning newsletter published by www.equitymaster.com. His writing has appeared across various other publications in India. These include The Times of India, Business Standard,Business Today, Business World, The Hindu, The Hindu Business Line, Indian Management, The Asian Age, Deccan Chronicle, Forbes India, Mutual Fund Insight, The Free Press Journal, Quartz.com, DailyO.in, Business World, Huffington Post and Wealth Insight. In the past he has also been a regular columnist for www.rediff.com. He has lectured at IIM Bangalore, IIM Indore, TA PAI Institute of Management and the Alliance University (Bangalore). He has also taught a course titled Indian Economy to the PGPMX batch of IIM Indore. His areas of interest are the intersection between politics and economics, the international financial crisis, personal finance, marketing and branding, and anything to do with cinema and music. He can be reached at vivek.kaul@gmail.com

One Response to EMIs down by Rs 20 per lakh, we will all buy cars now

  1. denseidiot says:

    If someone’s job depends on them not understanding something then they .. will not understand it. That is why builders and motorwalas won’t understand what you are saying.

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