Mr Subramanian, Lower Interest Rates Do Not Always Lead to More Bank Loans

Arvind_Subrahmaniyam

“Lower interest rates lead to higher lending,” is something that most economists firmly believe in. The beliefs of Arvind Subramanian, the chief economic adviser to the ministry of finance, are not an exception to this rule.

Hence, not surprisingly in a lecture a few days back he came out all guns blazing against the Reserve Bank of India(RBI) for not cutting 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 loan. We say sort of a benchmark here because there are other factors which go into deciding what rate of interest that banks charge on their loans.

Subramanian wants the RBI to cut the repo rate further from its current level of 6.25 per cent. As he said: “Inflation pressures are easing considerably… the inflation outlook is benign because of a number of economic developments… Against this background, most reasonable economists would say that the economy needs all the macroeconomic policy support it can get: instead, both fiscal policy and monetary policy remain tight.

The point here being that current inflation is under control and from the looks of it, future inflation should also be under control. And given this, the RBI must cut its repo rate. The RBI last cut the repo rate in October 2016. And as and when it cuts the rate further, the hope is that the banks will cut their lending rates. Only then will people and industries both borrow and spend more. This will give a flip to the economy. QED.
Subramanian’s point is well taken. Nevertheless, does it make sense? We will deviate a little here before we arrive at the answer.

The RBI Monetary Policy Report released in early April 2017 points out that the decline in the one-year marginal cost of funds based lending rates (MCLRs) of banks between April and October 2016 was just 15 basis points. This when the repo rate was cut by 50 basis points. Hence, even though the RBI cut its repo rate by 50 basis points, the banks cut their lending rates by just 15 basis points, a little under a one-third. One basis point is one hundredth of a percentage.

Post demonetisation “27 public sector banks have reduced their one-year median MCLR in the range of 50 to 105 bps, and 19 private sector banks have done so in the range of 25 to 148 bps.” This when the repo rate has not been cut at all. On an average the one year MCLRs of banks fell by 70 basis points to 8.6 per cent.

What has happened here? A cut in the repo rate barely makes any difference to the cost at which banks have already borrowed money to fund their loans. But demonetisation did. The share of the “low cost current account and savings account (CASA) deposits in aggregate deposits with the SCBs went up to 39.2 per cent (as on March 17, 2017) – an increase of 4.0 percentage points relative to the predemonetisation period”. This is because people deposited the demonetised notes into the banks and this money was credited against their accounts.

This basically meant that banks suddenly had access to cheaper deposits because of demonetisation. And this in turn led them to cut interest rates on their loans, despite no cut in the repo rate. The RBI’s repo rate continued to be at 6.25 per cent during the period.

A cut in lending rates is only one part of the equation. The bigger question has it led to higher borrowings? Are people and businesses borrowing more because lending rates are now lower than they were in the past? And this is where things become interesting.
The total deposits of banks between October 28, 2016 (before demonetisation) and December 30, 2016 (the last date to deposit demonetised currency into banks) went up by 6.41 per cent to Rs 10,568,17 crore. This was a huge jump during a period of two months. This sudden increase in liquidity led to banks cutting their deposit rates and then their lending rates.

Interestingly, the total deposits of banks have continued to remain stable and as of April 30, 2017, were at Rs 10,509,337 crore. This is a minor fall of 0.6 per cent since December 2016.

Between end October 2016 and end April 2017, only around 36 per cent of the incremental deposits raised by banks were loaned out. (We are looking at non-food credit here. The total bank loans that remain after we adjust for the loans that have been given to the Food Corporation of India and other state procurement agencies for the procurement of rice and wheat produced by farmers).

This means for every new deposit worth Rs 100, the bank loaned out just Rs 36, despite a cut in interest rates.

If we were to look the same ratio between end October 2015 and end April 2016, it projects a totally different picture. 116 per cent of the incremental deposits during the period were lent out. This means for every new deposit worth Rs 100, the bank loaned out Rs 116.  This means that deposits raised before the start of this period were also lent out.

Hence, a greater amount of lending happened at higher interest rates between October 2015 and April 2016. And this goes totally against Subramanian’s idea of the RBI needing to cut the repo rate. It also goes against the idea of banks lending more at lower interest rates.

Given this, low interest rates are only a part of the story. If that is not leading to higher lending, it doesn’t help in anyway. Lending isn’t happening due to various reasons, which we keep discussing. Demonetisation has only added to this issue.

Also, a fall in interest rates hurts those who depend on a regular income from fixed deposits to meet their expenditure. It also hurts those who are saving for their long-term goals. In both the cases, expenditure has to be cut down. In one case because enough regular income is not being generated and in another case in order to be able to save more to reach the investment goal. And this cut in spending hurts the overall economy. Interest rates are also about the saver and depositor.

We are yet to see a professional economist talk from this angle. To them it is always a case of garbage in garbage out i.e. lower interest rates lead to increased lending. This is simply because most professional economists these days get trained in the United States where the system is totally different and lower interest rates do lead to a higher borrowing by businesses and people.

But that doesn’t necessarily work in India. It is a totally different proposition here.

The column originally appeared in Equitymaster on May 15, 2017.

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Cut Interest Rates by 2 per cent: The New Economics of Nirmala Sitharaman

Nirmala Sitharaman Spokesperson 11, Ashoka Road, New Delhi - 110001.

BA Kiya Hai, MA Kiya,
Lagta Hai Wo Bhi Aiwen Kiya.
– Gulzar in Mere Apne

The commerce and industry minister Nirmala Sitharaman wants the Reserve Bank of India(RBI) to cut the repo rate by 200 basis points.

Yes, you read that right!

200 basis points!

The repo rate is the rate at which banks borrow from the RBI on an overnight basis. One basis point is one hundredth of a percentage. The repo rate currently stands at 6.5 per cent.

I still hold that the cost of credit in India is high. Undoubtedly, particularly MSMEs which create a lot of jobs contribute to exports… are all hard pressed for money and for them, approaching a bank is no solution because of the prevailing rate of interest. I have no hesitation to say, yes 200 bps, I would strongly recommend,” Sitharam told the press yesterday in New Delhi.

What Sitharaman was basically saying is that India’s micro and small and medium enterprises(MSMEs) are not approaching banks for loans because interest rates are too high. Given this, the RBI should cut the repo rate by 200 basis points and in the process usher in lower interest rates for MSMEs.

This, according to Sitharaman, was important because MSMEs create a lot of jobs and contribute to exports, and hence, should be able to borrow at a lower interest rates, than they currently are. As per the National Manufacturing Policy of 2011, the small and medium enterprises contribute 45 per cent of the manufacturing output and 40 per cent of total exports.

Hence, Sitharaman was batting for the MSMEs. But is it as easy as that?

That politicians don’t understand economics, or at least pretend not to understand it, is a given. But Sitharaman is a post graduate in economics from the Jawaharlal Nehru University in Delhi. (You can check it out here). For her, to make such an illogical remark, is rather surprising.

Not that the RBI is going to oblige her, but for a moment let’s assume that it does, and cuts the repo rate by 200 basis points, in the next monetary policy statement, which is scheduled for October 4, 2016, or over the next few statements.

What is going to happen next? Will banks cut their lending rates by 200 basis points? Only, when the banks cut their lending rates by 200 basis points, is the MSME sector going to benefit.

Banks only borrow a small portion of money from the RBI on an overnight basis and pay the repo rate as interest. A major portion of the money that they lend is borrowed in the form of fixed deposits. Hence, lending rates cannot fall by 200 basis points, unless fixed deposit interest rates fall by at least 200 basis points. (I use the word at least because banks tend to cut deposit rates faster than lending rates).

Wil the banks cut deposit rates by 200 basis points? Let’s assume that they do. If the deposit rates are cut by such a huge amount at one go, people will not save money in fixed deposits. Money will move into post office savings schemes, which offer a significantly higher rate of interest in comparison to fixed deposits (which they do even now, but with a cut the difference will be substantial).

Over a longer period of time, money will also move into real estate and gold, as people start looking for a better rate of return, higher than the prevailing inflation. This will lead to the financial savings of the nation as a whole falling. And banks in order to ensure that deposits keep coming in, will have to reverse the 200 basis points cut and start raising interest rates.

This is precisely how things played out between 2009 and 2013, when household financial savings fell from 12 per cent of the GDP to a little over 7 per cent of the GDP. Meanwhile, the interest rates went up, in order to attract financial savings.

This is Economics 101, which a post graduate in economics from a premier university in the country, should be able to understand.

Another important issue that our politicians seem to forget, over and over again, is the importance of fixed deposits, as a mode of saving, in an average Indian’s life. In 2013-2014, the latest year for which data is available, 69.23 per cent of total household financial savings, were in deposits.

Of this nearly 62.02 per cent was with scheduled commercial banks and 4.19 per cent with cooperative banks and societies. Nearly 2.61 per cent was invested in deposits of non-banking companies.

What does this tell us? It tells us that for the average Indian, the fixed deposit is an important form of saving. For the retirees it is an important form of regular income. Now what happens if fixed deposit interest rates are cut by 200 basis points? The regular income from the fresh money that retirees invest, will come down dramatically. Also, when their old fixed deposits mature, they will have to be invested at a significantly lower rate of interest.

This means that they will have to limit their consumption in order to ensure that they meet their needs from the lower monthly income that their fixed deposits are generating.

What about those who use fixed deposits as a form of saving? (I know that fixed deposits are a terribly inefficient way of saving, but that is really not the point here). Those who are using fixed deposits to save money, for their retirement, for the education and wedding of their children, will now have to save more money, in order to ensure that they are able to create the corpus that they are aiming at. This will also mean lower consumption.

Ultimately lower consumption will impact MSMEs as well, because there won’t be enough buyers for what they produce, as people consume less.

Those individuals who are not in a position to save the extra amount in order to make up for lower interest rates, will end up with a lower corpus in the years to come.

The point being that MSMEs do not operate in isolation. And the level of interest rates impacts the entire economy and not just the MSMEs, as Sitharaman would like us to believe.

Further, even if fixed deposit rates fall by 200 basis points, banks may still not be able to offer low interest rates to MSMEs, simply because they need to charge a credit risk premium i.e. factor in the riskiness of the loan that they are maing.

In case of the State Bank of India, the gross non-performing assets of SMEs stands at 7.82 per cent, as on March 31, 2016. This means that for every Rs 100 that the bank has lent to an SME, close to Rs 8 has been defaulted on. This risk of default needs to incorporated in the interest rate that is being charged.

And finally, the interest rates on fixed deposits of greater than one year are currently in the region of 7 to 7.5 per cent. This is when the rate of inflation has already crossed 6 per cent. In July 2016, the rate of inflation as measured by the consumer price index was at 6.07 per cent.

If fixed deposit rates are cut by 200 basis points, the interest rates will fall to around 5 to 5.5 per cent. This when the rate of inflation is greater than 6 per cent. This would mean that the real rate of interest (the difference between the nominal rate and the rate of inflation) would be in a negative territory. This is precisely how things had played out between 2009 and 2013 and look at the mess it ended up creating for the Indian economy.

Given these reasons, it is best to say that Sitharaman’s prescription would be disastrous for the Indian economy.

The column originally appeared in Vivek Kaul’s Diary on August 25, 2016

The Biggest Challenge for the New RBI Governor Urjit Patel is…

o-URJIT-PATEL-facebook-1

 

On Saturday, August 20, 2016, the Narendra Modi government appointed Urjit Patel, as the 24th governor of the Reserve Bank of India(RBI). He will take over fromRaghuram Rajan, on September 4, 2016.

Since Patel’s appointment two days back, a small cottage industry has emerged around trying to figure out what his thinking on various issues is. The trouble is that Patel has barely given any speeches, or interviews, for that matter, since he became the deputy governor of the RBI, in January 2013.

A check on the speeches page of the RBI tells me that he has given only one speech (you can read it here) and one interview (you can read it here) in the more than three and a half years, he has been the deputy governor of the RBI.

You can’t gauge much about his thinking from the speech which is two and a half pages long. As far as the interview goes, Patel has answered all of three questions. Some of his thinking can be gauged from the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework¸ of which he has the Chairman. The report was published in January 2014 and ultimately became the basis for the formation of the monetary policy committee, which will soon become a reality.

There are also a few research papers that he has authored over the years.

Given this, Patel’s thinking on various issues will become clearer as we go along and as he interacts more with the media in the days to come. While he may have managed to avoid the media in his role as the deputy governor that surely won’t be possible once he takes over as the RBI governor. He may not make as many speeches as his predecessor did (which is something that the Modi government probably already likes about him), but there is no way he can avoid interacting with the press, after every monetary policy statement, and giving interviews now and then.

Given this, the policy continuity argument being made across the media about Patel being appointed the RBI governor, is rather flaky. There isn’t enough evidence going around to say the same. The only thing that can perhaps be said from what Patel has written over the years is that his views on inflation seem to be in line with Rajan’s thinking. Also, some of the stuff that is being cited was written many years back. And people do change views over the years. There is no way of knowing if Patel has.

The Challenges for the new RBI governor

While, his thinking on various issues may not be very clear, it doesn’t take rocket science to figure out what his bigger challenges are. Take a look at the following chart. It maps the inflation as measured by the consumer price index since August 2014.

Inflation as measured by the consumer price index

The chart tells us very clearly that the inflation as measured by the consumer price index is at its highest level since August 2014. In August 2014, the inflation was at 7.03 per cent. In July 2016, it came in at 6.07 per cent.

Why has the rate of inflation as measured by the consumer price index, spiked up? The answer lies in the following chart which shows the rate of food inflation since August 2014.

 

Food Inflation

 

Like the inflation as measured by the consumer price index, the rate of food inflation is also at its highest level since August 2014. In August 2014, the food inflation was at 8.93 per cent. In July 2014, the food inflation was at 8.35 per cent. Food products make for a greater chunk of the consumer price index.

What this tells us is that the inflation as measured by the consumer price index spikes up when the food inflation spikes up. And that is the first order effect of high food inflation. This becomes clear from the following chart.

Inflation

But what can the RBI do about food inflation?

There is not much that the RBI can do about food inflation. And this is often offered as a reason, especially by the corporate chieftains and those close to the government (not specifically the Modi government but any government), for the RBI to cut the repo rate. The repo rate is the rate of interest that the RBI charges commercial banks when they borrow overnight from it. It communicates the policy stance of the RBI and tells the financial system at large, which way the central bank expects interest rates to go in the days to come.

The trouble is that things are not as simplistic as the corporate chieftains make them out to be. While, the RBI has no control over food inflation (and not that the government does either), it can control the second-order effects of food inflation.

As D Subbarao, former governor of the RBI, writes in his new book Who Moved My Interest Rate?-Leading the Reserve Bank of India Through Five Turbulent Years: “What about the criticism that monetary policy is an ineffective tool against supply shocks? This is an ageless and timeless issue. I was not the first governor to have had to respond to this, and I know I won’t be the last. My response should come as no surprise. In a $1500 per capita economy-where food is a large fraction of the expenditure basket-food inflation quickly spills into wage inflation and therefore into core inflation…When food has such a dominant share in the expenditure basket, sustained food inflation is bound to ignite inflationary expectations.”

Given this, the entire logic of the RBI cutting the repo rate because it cannot manage food inflation is basicallybunkum. Food inflation inevitably translates into overall inflation and that is something that the RBI has some control over, through the repo rate. If this is not addressed, second order effects of food inflation can lead to an even higher inflation as measured by the consumer price index. And this will hurt a large section of the population.

As Subbarao writes: “The Reserve Bank of India cannot afford to forget that there is a much larger group that prioritizes lower inflation over a faster growth. This is the large majority of public comprising of several millions of low-and-middle-income households who are hurt by rising prices and want the Reserve Bank to maintain stable prices. Inflation, we must note, is a regressive tax; the poorer you are, the more you are hurt by rising prices.”

But one cannot expect corporate chieftains who have taken on a huge amount of debt over the years, in order to further their ambitions, to understand this rather basic point. Given this, this hasn’t stopped them from demanding a repo rate cut from the new RBI governor. (You can read more about it here). The government has also made it clear over and over again that it wants the RBI to cut the repo rate. Given that, it is the biggest borrower, this is not surprising. Since January 2015, the RBI has cut the repo rate by 150 basis points to 6.5 per cent. One basis point is one hundredth of a percentage.

As Subbarao writes: “The narrative of our growth-inflation debate is also shaped by what I call the ‘decibel capacity’. The trade and the industry sector, typically a borrower of money, prioritizes growth over inflation, and lobbies for a softer interest-rate regime.”

The people who invest in deposits unlike the corporate chieftains are not in a position to lobby. But it is important that the RBI does not forget about them.

Hence, it is important that people are offered a positive real rate of interest on their fixed deposits. The real rate of interest is essentially the difference between the nominal rate of interest offered on fixed deposits and the prevailing rate of inflation. A positive real rate of interest is important in order to encourage people to save and build the domestic savings of India, which have been falling over the last few years.

This was one of the bigger mistakes made during the second-term of the Manmohan Singh government.

As outgoing governor Raghuram Rajan told NDTV in an interview sometime back “When inflation was 9 per cent they [i.e. depositors] were getting 9 per cent. This meant earning nothing in real terms and losing everything in inflation.”

This wasn’t the case for many years. As Rajan explained in a June 2016 speech: “In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.”

Inflation up, savings down

Take a look at the following chart clearly shows that between 2008 and 2013, the real rate of return on deposits was negative. In fact, it was close to 4 per cent in the negative territory in 2010.

 

Inflation as measured by the consumer price index

 

High inflation essentially ensured that India’s gross domestic savings have been falling over the last decade. Between 2007-2008 and 2013-2014, the rate of inflation as measured by the consumer price index, averaged at around 9.5 per cent per year. In 2007-2008, the gross domestic savings peaked at 36.8 per cent of the GDP. Since then they have been falling and in 2013-2014, the gross domestic savings were at 30.5 per cent of the GDP, having improved from a low of 30.1 per cent of GDP in 2012-2013.

This fall in gross domestic savings has come about because of a dramatic fall in household financial savings. Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6 per cent of the GDP. In 2009-2010, it rose to 12 per cent of GDP. By 2011-2012, it had fallen to 7 per cent of the GDP. The household financial savings in 2014-2015, stood at 7.5 per cent of GDP. Chances of this figure having improved in 2015-2016 are pretty good given that a real rate of return on deposits is on offer for savers, after many years.

If a programme like Make in India has to take off, India’s household financial savings in particular and overall gross domestic savings in general, need to be on solid ground. And that is only going to happen if people are encouraged to save by ensuring that they make a real rate of return on their deposits. In fact, if India needs to grow at 10 per cent per year, an estimate made in Vijay Joshi’s book India’s Long Road suggests that the savings rate will have to be around 41 per cent of the GDP.

As Rakesh Mohan and Munish Kapoor of the International Monetary Fund write in a research paper titledPressing the Indian Growth Accelerator: Policy Imperatives: “In the near future, we expect financial savings to be restored to the earlier 10 per cent level, as inflation subsides, monetary conditions stabilize and households begin to obtain positive real interest rates on their deposits and other financial savings. Financial savings are then projected to increase gradually to around 13 per cent by 2027-32.”

And how is this going to happen? As Mohan and Kapoor point out: “A sustained reduction in inflation that leads to the maintenance of low nominal interest rates, but positive real interest rates, will help in restoring corporate profitability, while encouraging household savings towards financial instruments.”

The point is that a scenario where a positive real rate of return is available to depositors is very important. But is that how things will continue to be? Take a look at the following chart, which plots the repo rate and the consumer price inflation.

Inflation as measured by the consumer price index

As can be seen from the graph, the difference between the repo rate (the orange line) and overall inflation (i.e. inflation as measured by the consumer price index) has narrowed considerably and is at its lowest level in the last two years. This effectively means that the real rate of return on fixed deposits offered by banks has been falling as the rate of inflation has been going up. (Ideally, I should have taken the average rate of return on fixed deposits instead of the repo rate, but that sort of data is not so easily available. Hence, I have taken the repo rate as a proxy).

This is not a good sign on several counts. In a country like India where deposits are a major way through which people save, high inflation leading to lower real rates of interest which effectively means that they are not saving as much as they should. This is something that most people do not seem to understand.

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.”

Now replace China with India in the above paragraph and the logic remains exactly the same. Given that a large portion of the Indian household financial savings are invested in bank deposits, any fall in interest rates (as the corporate chieftains regularly demand) should make people feel poorer and in the process negatively impact consumption, at least from the point of savers.

Given this, the biggest challenge for Urjit Patel will be to not taken in by all these demands for lower interest rates and ensure that the deposit holders get a real rate of interest on their fixed deposits.

Further, it is unlikely that he will cut the repo rate given that as the monetary policy committee comes in place, the RBI needs to maintain a rate of inflation between 2 to 6 per cent. In July 2016, the rate of inflation was over 6 per cent.

The column originally appeared in Vivek Kaul’s Diary on August 22, 2016

 

Bhaktonomics 101: All You Wanted to Know but Were Afraid to Ask

ARTS RAJAN

There is economics and then there is Bhaktonomics–or so called economics which is used regularly these days, to justify the actions of the Narendra Modi government.

This new faction of economics has never been explored before—at least not until today. In this column I will look at Bhaktonomics that is being used to justify why Raghuram Rajan should not have been offered a second term, as the governor of the Reserve Bank of India.

Here are a few arguments being made:

a) Rajan wasn’t cutting interest rates fast enough: This is an old argument that keeps getting made whenever a central bank does not cut interest rates as the government of the day would like it to. So the followers of Bhaktonomics say that Rajan should not have got a second term because he was not cutting interest rates fast enough.

The irony is that Rajan did cut the repo rate. The repo rate has been cut by 150 basis points since January 2015. 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.

But let’s leave that aside for a moment. Hence, the argument is Rajan wasn’t cutting interest rates fast enough. And because he wasn’t cutting interest rates fast enough, the bank lending had been growing at a slow rate. Since bank lending has been growing at a slow rate, individuals haven’t been borrowing to spend and companies to expand. Hence, economic growth hasn’t been robust enough. Given this, Rajan had to go.

But didn’t India grow at 7.6% in 2015-2016? Isn’t India the fastest growing major economy in the world? I personally don’t believe that India is growing at 7.6%. There are many other sceptics as well. But try telling that to the practitioners of Bhaktonomics and see how they react.

So, if India is indeed growing at 7.6%, and is the fastest growing major economy in the world, then Rajan has cut interest rates fast enough. And if he has cut interest rates fast enough, why is he being fired? Okay, okay. He has not been fired. He has chosen to go on his own.

If India is growing at 7.6%, then Rajan has cut interest rates fast enough. Or to put it as the conventional economists do, he hasn’t been behind the curve. On the flip side, if he hasn’t cut interest rates fast enough, then India isn’t growing at 7.6%. The broader point being that you can’t have it both ways like the Bhaktonomists are currently.

There are other points on the interest rate front that need to be made here. Rajan ensured that the real rate of interest on deposits was in positive territory, after a long time. This basically means that the difference between the nominal rate of interest on deposits minus the prevailing rate of inflation, is in positive territory.

This worked well for savers who had seen inflation eat away their hard earning during the Manmohan Singh years. It has also helped household financial savings grow, as less money went into gold and real estate, in comparison to the past. It is ultimately these financial savings which will finance the Make in India programme. So Rajan essentially was batting for the government and not against it, as Bhaktonomists have been pointing out.

But a real rate of interest for depositors means that the government had to bear a high rate of interest on its borrowings, something it is clearly not comfortable doing. This is after many years of paying a lower rate of interest on its borrowings than the prevailing rate of inflation.

Take a look at the following chart:

 

The green line is the rate of inflation. And the red line is the interest that the government pays on what it borrows. Between 2007 and 20013, the government paid a lower rate of interest than the prevailing rate of inflation.

The real rate of interest available to the depositors these days, does not allow the government to do that. Hence, as the biggest borrower going around, it wants lower interest rates. QED.

The saver be dammed. Bhaktonomics has no place for the savers. They are only bothered about the borrowers, which includes the government and the crony capitalists.

b) Individuals are not important/Nobody is indispensable: This is another point that is being vociferously made to justify the exit of Rajan. This is absolute rubbish. If that was the case then Manmohan Singh, would have still been prime minister.

Individuals make institutions and governments. They make institutions and they destroy them as well. Hence, individuals are important. What India lacks are institutions. One man cannot take this country out of the rut that it is in. Good institutions can. And institutions are ultimately built as well as nurtured by individuals. So saying that individuals are not important is not even an argument.

Also, India’s government these days gets as much attention as it does, globally, primarily because Narendra Modi heads it. Modi is an individual. His being the head of the Indian government gives it more credibility than the last one and given that he matters. And like he matters, so does Rajan, when it comes to the RBI.

Further, you don’t hound out an employee who is doing well, especially when you have a serious talent crunch anyway, when the best brains do not want to work for the government (and I mean any Indian government here not just this government) and stay far away from it. If something is working why try and destroy, in order to fix it again? Beats me. Perhaps, Bhaktonomics has an explanation for this as well.

Also, the next RBI governor, whoever he or she is, will take time to settle into the job. And precious time will be lost. This is when inflation has started to go up again. So have oil prices. The cleaning up of bad loans of banks has reached a very important stage. Continuity would have been good here.

In fact, The Indian Express reports that earlier this year the government scrapped the search for a new chief of the Securities and Exchange Board of India(Sebi) and extended the term of UK Sinha on the pretext that ““continuity may be desirable” at times of “excessive volatility — mainly due to external factors””.

If this was true for Sebi earlier this year, it is more than true for the RBI at this point of time. So, why the double standards? Also, UK Sinha, the Sebi chief, like Rajan, is a UPA appointee.

c) It’s the government’s prerogative to decide who works for it: This is the third argument being made justifying Rajan’s exit and is by far the most sensible of the lot. Also, it is better than saying nobody is indispensable.

But is this the way you hound out an RBI governor, when RBI remains one of the few government institutions which hasn’t degraded over the years? You don’t let an unelected member of Parliament run a malicious campaign against the RBI governor and then come out and say this is not the party’s stated position on the issue.

If you didn’t want him, the same could have been communicated to him, in a good way. Tata, bye bye.

The way Rajan’s exit has been handled, it is clear that the message that the government wants to send out is, that if you want to work for us, then you need to be a cheerleader (or  team player as the euphemism goes), and if you have an opinion your own, then it’s better to keep your mouth shut.

As Chandan Mitra of the BJP put it in a column on NDTV.com: “He also demonstrated a less-than-patriotic enthusiasm to play cheerleader, expected to tom-tom his government’s achievements.”

The column originally appeared in Vivek Kaul’s Diary on June 21, 2016

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

Money Printing: Rajan Launches QE Lite to Bring Down Interest Rates

ARTS RAJAN

In the first monetary policy statement for this financial year, Raghuram Rajan, the governor of the Reserve Bank of India(RBI) cut the repo rate by 25 basis points to 6.5%.

One basis point is one hundredth of a percentage. 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.

In the column dated March 30, 2016, I had said that it is best if the RBI cuts the repo rate 25 basis points at a time and not more.

My logic for writing this was fairly straightforward. From January 2015 onwards, the RBI had cut the repo rate by 125 basis points. In comparison, the banks had cut their lending rates by only around 60 basis points. Meanwhile, they have cut the interest rates on their fixed deposits by more than 100 basis points.

This means that the banks have cut their lending rates at a very slow pace. Hence, there was no point in the RBI cutting the repo rate by more than 25 basis points, given that the banks have not passed on that cut to their prospective and current borrowers, in the form of lower lending rates.

In this scenario the best strategy for the RBI is to cut the repo rate 25 basis points at a time and then take a check if the cut has been passed on to the borrowers by banks.

And this is precisely what Rajan did yesterday by cutting the repo rate by 25 basis points. Honestly, the cut in the repo rate was not the most important part of yesterday’s monetary policy statement.

In the most important paragraph of the monetary policy, the RBI said that it will “continue to provide liquidity as required but progressively lower the average ex ante liquidity deficit in the system from one per cent of NDTL [net demand and time liabilities] to a position closer to neutrality.”

What does this mean in simple English? There is a certain demand for money that the banking system has. But there is only a certain supply of it going around which is not enough to fulfil demand. The difference is referred to as liquidity deficit.

Hence, banks cannot borrow as much as they want to from the banking system. In this scenario they have to pay a higher rate of interest to borrow.

The monetary policy statement of the RBI puts the liquidity deficit at 1% of demand and time liabilities. This means that the liquidity deficit in the banking system is at 1% of the total current account deposits, savings account deposits and fixed deposits, of banks.

As on March 18, 2016, the total demand and time deposits of banks stood at Rs 93,786,60 crore. The liquidity deficit is 1% of this and hence works out to around Rs 93,786 crore. This is where theoretically the deficit in the banking system should have been.

But the actual deficit is more than this. Rajan in his interaction with the media after presenting the monetary policy conceded that the actual liquidity deficit was around Rs 50,000-60,000 crore more than the RBI had estimated. This means that the actual daily liquidity deficit is around Rs 1,50,000 crore.

There are multiple reason for the same. Assembly elections are currently on in several states. Around this time, the cash in hands of the public increases. As Rajan said: “you can guess as to reasons why…we also guess.” This increase is not only in the states that go to elections but also in neighbouring states.

Then there was the issuance of tax-free bonds. Further, before the interest rates on small saving schemes were cut there was an inflow of money into these schemes. All these factors have essentially ensured that the liquidity deficit in the banking system is around Rs 1,50,000 crore.

The RBI now plans to bring down this deficit to a position closer to neutrality. The RBI plans to steadily reduce this deficit. The question is how will the RBI do this? The central bank will have to buy assets from banks.

One way of going about it is to carry out open market operations and buy bonds from banks. In fact, the RBI announced an open market operation of Rs 15,000 crore, yesterday.

The question is where will the RBI get this money from? The RBI, like any other central bank, has the ability to create money out of thin air by printing it, or rather by creating it digitally these days.

And this is precisely what the RBI will do—it will print money to buy bonds. When it buys bonds, it will pay for it through this freshly created money. When this freshly created money enters the banking system, the supply of money will go up and the liquidity deficit will come down. This will push down interest rates and in the process banks will pass on lower interest rates to the end consumers.

Of course this is not going to happen overnight and will happen over the course of this financial year and perhaps even the next.

In fact, what the RBI is trying to do is similar to what happened in the aftermath of the financial crisis that started in September 2008. The Federal Reserve of the United States decided to print money and buy bonds, in order to drive down interest rates, so that people would borrow and spend more. This is referred to as quantitative easing or QE.

The RBI is also doing a smaller version of QE. We can perhaps call it QE lite.

There were other moves also to help banks lower lending interest rates. Up until the RBI had maintained a difference of 100 basis points between the reverse repo rate and the repo rate.

While repo rate is the rate at which the RBI lends to banks, the reverse repo rate is the rate at which the RBI borrows from banks. Before today, the repo rate was at 6.75% and the reverse repo rate was at 5.75%. The difference, as mentioned earlier, was 100 basis points.

The RBI cut the repo rate by 25 basis points to 6.5%. At the same time, it increased the reverse repo by 25 basis points to 6%, thus narrowing the difference to 50 basis points. Hence, banks will now pay a lower interest when they borrow from the RBI and get a higher interest when they have excess funds, which they can park at the RBI. This basically will help banks to earn more and make it more likely for them to cut their lending rates.

Further, banks need to maintain 4% of their demand and time deposits with the RBI as a cash reserve ratio(CRR). Currently, the banks need to maintain 95% of the required CRR with banks on a daily basis. This has been lowered to 90%. This will help ease the pressure on banks and they will have more free cash. This should again help them cut their lending rates.

Up until now, the RBI repo rate cuts led to interest rate on deposits being cut more rapidly than lending rates. This time around, the lending rates are also likely to be cut.

Watch this space!

The column was originally published on Vivek Kaul’s Diary on April 6, 2016

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