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What is this fuss about Interest Rates?

Do you get confused with this hullabaloo about interest rates?

Market Pundits, Corporate Honchos, RBI Governor and Finance Ministry seemingly can’t stop talking about it. There are talks about reducing rates by 25 BPS (0.25%) or 50 BPS (0.50%) all the time. Sometimes they get reduced, sometime they don’t.

Whenever there is RBI Policy Announcement Day, all the news channels and newspapers feverishly track the developments about the outcome of the Policy Announcement followed by a high voltage discussion and debate around it.

You may wonder, what is this fuss all about? After all how does a rate cut of 0.25% or 0.50% will make any difference to any one? You may mentally calculate the impact of 0.25% or 0.50% but you are puzzled. The impact looks minimal, rather almost insignificant.

I have been there myself.

Let me take a shot to try to explain the fuss behind ‘interest rates’. But let me start by saying that Media though by nature has a tendency to overplay any event.

Interest rates, in reality, are critical. Interest Rates are the most important economic variable for any country. Let me give you a hint as to why is it so important?

Look at any successful economy in the world and you will find long and sustained periods of low interest rates. Low interest rates are a foundation on which economic growth is laid upon.

The next question is why & how? Ok so here we go. At a heart of any successful economy lies its Industry. And the Industry is driven by one and only motive which is ‘Maximising Profits‘.

To make profits the cost of selling the goods should be higher than the cost of producing them. The cost of production has an element of interest rate as well. When you run large industries, you borrow money from various sources and pay interest against the borrowing.

Higher the interest rate, higher would be the cost of capital, assuming other costs are constant. The cost of goods would be high as well. Then to make profits one will have to sell at higher prices. A higher selling price leads to lesser demand for the product and therefore lesser sales for the industry.

Also there is a possibility that the buyer may not be able to afford the products at higher prices.

Had the interest on capital been lower, not only it would reduce the cost for the industry and cost for the buyer, it will also leave more money in the hands of both the industry and buyer to spend on other consumption items.

The other thing is from the buyer’s perspective.

In current times, even a buyer takes money on credit to buy goods. For example, a House, Car, Vacation, Education and others. Now when you as a buyer have to pay higher loan instalments because of higher interests, your affordability decreases. If you were to buy a Rs 10 Lacs car, may be now you’ll buy just a Rs 8 Lacs car.

If you look at it in above case it’s a double whammy for that car company – firstly because the interest rates are higher, the cost of production would have gone up and at the same time their consumer are buying less due to rise in financing cost.

You’ll therefore notice that capital-intensive companies like manufacturing and construction companies are most impacted by higher interest cost and are most vocal about bringing them down. Yes, this includes real estate companies whose customer base almost entirely depends upon Finance to make their purchases.

Until here we have seen that

  • Large businesses which need credit are unfavourably impacted by higher interest rates, and
  • Consumers who buy on Loans are also unfavourably impacted by higher interest rates.

You may be wondering if low interest rates are that useful for the economy than why are they high in first place. After all it’s in the hand of central banks to reduce the rates and keep everyone happy – right? No, not that fast.

To understand this, let’s first understand the role of Reserve Bank.

The Reserve Bank of India (RBI)

One of the primary roles of the RBI, as the issuer of Currency our own Indian Rupee, is to maintain its value.

For example, today if Rs 100 can buy 1 KG of Apples than in future also it should be able to buy 1 KG of Apple for the same money. But we know that’s not the case and money does loose it value. We commonly know this phenomenon as inflation or price rise. 1 KG of Apple, if it costs Rs. 100 today, will cost Rs. 110 or more in future.

Now this loss of value of Rupee makes RBI uncomfortable. To counter the impact of fall in value of Rupees the RBI decides, Okay, let me give you higher interest rates on your deposits so as to compensate for the loss of value of the Rupee.

RBI doesn’t takes any deposits but sets the interest rates on the basis of which Banks in the India fix their deposit rates. So whenever inflation goes up, RBI tends to increase the interest rates so as to compensate for loss in the value of Rupee. This increase in interest rates results in higher cost of capital for the economy, reducing viability of business. Whenever the inflation inches lower RBI can than go ahead and reduce the interest rates, which has a positive cascading impact on the economy.

So now we understand that RBI has to maintain the balance between Inflation and Interest rates and it cannot arbitrarily reduce interest rates.

Having said so, our initial query still remains unanswered.

Why is there so much fuss about 0.25% or 0.50% reduction in interest rates?

Let’s dive in.

Business or Economy runs not only on present events but on the expectation of future as well.

As we understood earlier that RBI has to keep interest rates high to counter inflation. The thing about inflation is that it tends to be sticky and takes long time to change its course. When inflation starts to inch up, it tends to stay there for years together. And the same is true for other side as well – When inflation comes down, it tends to stay down for quite some time before it starts raising its head.

RBI understands this and so do the people in general. Therefore when they see that the RBI is reducing rates, even by small amount, they are hopeful about the fact that RBI believes that lower inflation is there to stay. There’s no better news for an economy than a combination of lower inflation coupled by reduction of rates by RBI.

The thing is that increase or decrease in rates is structural and cyclical in natureFor example, when RBI reduces the rates it just doesn’t do it one off, usually it tends to be a cycle, spread over time when interest rates are reduced by a few percentage points giving a kicker to the economy.

Stock markets rejoice as it is a symbolic sign of lower cost of capital and hence increased productivity. Consumers rejoice as their affordability goes up due to lower interest rates. This euphoria translates into heightened business activity and consumer spending.

Let’s see what happened for real in the past.

In the chart below, the Repo rate movement has been mapped.

 

Here are the observations from the chart.

  • From Jan 2001 till Jan 2004, interest rate continued to fall
  • Post Jan 2007, it continued to rise till Jan 2007 and stayed there till end of 2009
  • From Jan 2010, it again started to inch up and than stabilised in 2013
  • From 2013 till now, it has come down a bit and the expectation are that it is headed south

Conclusion

We can see that interest rates trend up or down for long periods of time. It is expected to trend downwards for quite some time now. In fact, the current RBI Policy Rates is 7.25% and it’s historical low is 4.25%. Even if it reaches close to 4.25% it will be a big shot in the arm for Economic as well as Stock Market Investment growth.

Thank you for reading

Ashish

I am Kollectifying, will you

@Kollectify

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8 Comments

  1. EXCELLENT SUFF! Where are you based??

  2. Hello Alok, 

    I have written two looong posts in here and you are the first person to reply. But getting a reply from you is more than few thousand replies. I feel obligated to inform you that Asha (she is awesome) was kind enough to help me with edit related feedback on my articles. 

    A bit about me, I am working with a Mutual Fund company in Bombay. More importantly I am also working on a  stock market investing mobile app. In fact I write a blog for this and this article I have reproduced from my blog. 

    My coming soon page is http://www.kollectify.com and blog is http://www.kollectify.com/blog. If you happen to visit these, please let me warn you 🙂 you may hate the design or visuals.  I just hope you don’t hate the concept and the articles. 

    I have also connected with Abhik in Gurgaon some time ago to share my idea. Recently I also shared some of the app screens with him. Incidently he asked me to get in touch with you, but I wanted to connect with you with beta ideally or atleast the alpha build of the app. 

    Once again Alok – thanks a lot and a lot more for replying to my post. 

    Ashish

  3. Can you mail me directly at alok@rodinhood.com ?

  4. hey ashish, 

    could you pls add your twitter handle at the end? i would like to mention it while tweeting. 

    ps: sharad singh (our financial expert) will be commenting on your post!!

  5. Superb explanation of the stuff, keep them coming.

  6. Great write-up Ashish.

    You have simplified a difficult topic and it’s heartening to see people putting in efforts towards the same.

    Loved your blog too. Please keep it up.

    If I may add a few cents, I remember a flow-diagram which goes something like this:

    [RBI uses interest rates as a tool to control inflation and generate growth, which is also called as Monetary Policy (while Fiscal Policy is what government does; say reducing taxes).]

    Controlling Inflation

    RBI increases rates -> Bank incentivized to borrow from RBI -> Loan Rates for individuals increase -> Consumption decreases -> Prices Fall (Low Inflation)

    RBI increases rates -> Deposit rates also go up -> Individuals incentivized get high interest and postpone consumption -> Consumption decreases -> Prices Fall (Low Inflation)

    Enabling Growth

    RBI reduces rates -> Deposit rates reduce -> Saving is less attractive -> Consumption increases -> Economy grows

    RBI reduces rates -> Banks incentivized to lend -> Organizations do capital investments -> Economy grows

    Increasing/reducing interest rates reduces/provides money to organizations for investment and capital expenditures. This is commonly referred to as the Money Supply or Liquidity.

    The topic as such is quite intensive with interplay of Investments, Saving, Consumption and rates. Please don’t kill me for errata… 🙂

    Best Regards,

    Sharad

     

  7. Hey Asha

    Thanks for this. My twitter handle is @Kollectify 

    Ashish

    @kollectify

  8. Beautifully summarized Sharad. 

    Thanks a lot for having a look at my blog I truly appreciate your feedback. 

    Ashish

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