The “Interest”ing debate on interest rates

The banks are fighting tooth and nail to get the government to agree to reduce the interest rates on the savings account which is already a measly (at least from the common man’s perspective!) 3.5%. The savings account rates are dictated by the Reserve Bank of India which is an indirect indicator of the government’s policies. Thus we have the government on both sides and the banks in between. Of course RBI has done its share on another front through several CRR and repo rate cuts in the past one year or so urging the banks to cut their lending interest rates to which banks have responded but albeit slowly with more cuts expected soon, post-budget.

The debate on interest rates continue on the days leading to the budget. What are its consequences on our household budgets and pockets? Read on…

There has been a wide range of arguments flying back and forth in the government, banking and industry circles about the direction the interest rates need to move post budget 2009-10. Widespread speculation has been in the air about reduction of interest rates simultaneously on deposits and lending too.

The banks are fighting tooth and nail to get the government to agree to reduce the interest rates on the savings account which is already a measly (at least from the common man’s perspective!) 3.5%. The savings account rates are dictated by the Reserve Bank of India which is an indirect indicator of the government’s policies. Thus we have the government on both sides and the banks in between. Of course RBI has done its share on another front through several CRR and repo rate cuts in the past one year or so urging the banks to cut their lending interest rates to which banks have responded but albeit slowly with more cuts expected soon, post-budget.

Banks also have been under pressure for quite some time now to reduce their lending rates with its effects felt on the deposit rates as well. This is a prelude to the government looking at reducing the interest rates on its financial instruments a.k.a – the Public Provident fund, Postal Deposits, the National Savings scheme and the Kisan Vikas patra (all of which give assured returns in the range of 7.5- 8.25 percent pa).

Interestingly, all the above discussions have conveniently ignored the salaried individual, the “saver”  whose hard earned money is at stake in both the cases! Coincidently Indians, Interest rates and Injustice start with the same two letters. Is there a stronger link here? Let’s understand the game of interest rates better.

Why does the government want banks to reduce interest rates on lending?

The growth figures of 7-10% (as being indicated for the last couple of years) or correspondingly of 6.25-7.75% as indicated in the Economic Survey 2008-09 tabled on 02 July 09 can be only achieved if the industrial productions starts picking up. How?

A higher growth rate would be the result of higher production and higher consumption. In a more “economics” terminology everything depends on Cash Flow. The more people spend, the more will be the demand, the more the demand, the more will be the production. An increase in the production will also result in an increase in the consumption of raw materials. This is how the cycle (whoever invented the wheel must have been an economist!) of the economy moves and constantly gains momentum.

But for the past 12 months the wheel has slowed down due to a reduction in spending  As people are wary of spending precious “cash” in uncertain times, this led to a changed equation of the demand supply curve, thus leading to a decrease in production and the wheel started turning in the opposite direction.

If this trend has to be reversed then we the people have to be incentivized to spend. How will Mr. Finance Minister do that? If we have access to cheap (low interest rate) money we would be surely tempted to borrow from the lenders. It is very difficult for the common man (including economists) to resist the urge to spend.  And what’s even more interesting or rather ironical is that during recessions the human mind is all the more motivated to get the pleasures out of spending money!

If the interest rates on housing loans, personal loans, car loans and whatever you name loans are reduced there would be a boost in the people queuing up for these loans and the underlying product. All this leading to a steady increase in demand and supply of the consumables. And viola! we could have the cycle moving faster again. But, then why don’t banks reduce the lending rates readily?

The bank’s perspective

This is where “catching the tiger’s tail” story gains significance. For banks to reduce their rates of lending they need to have access to cheaper sources of money. Here again RBI’s repeated cuts of CRR and repo rates did help banks consider cutting down their lending rates seriously.

That apart, a major source of capital for banks and lenders is the deposits that we give them in return for the interest that they pay us annually. In the past few years the banks have also had to compete against the government supported small saving schemes like the PFF and the Postal deposits. This meant that to attract depositors to deposit their “hard-earned” money with the banks/lending institutions they need to be offered higher returns as compared to the small savings schemes.

Simple economics has taught us that if we buy something at X price and sell it at Y (Y being greater than X) then we make a profit. Banks have to do the same. If they borrow at say 9% from you they can lend to your neighbor for buying his car at a rate significantly greater than 9% to make some profit for themselves. Thus we have higher interest rates prevailing in the market.

The bottom-line

The simple analysis from all the above discussions is that we are stuck in a probably lose-lose situation especially if we have been investing our money in small savings or deposits with banks.

As seen earlier, the government looks keen on reducing the interest rates on deposits in banks (meaning our deposits will fetch us lower returns) and then reducing the interest rates on small savings (we again tend to get lower returns). At the same time they (the government and lenders) will try to get more growth and income by lending to us at lower rates so that we spend. In simpler terms, we will be in a situation where our expenses will go up and at the same time our income (from deposits) will go down. Ouch! Forget about going laughing all the way to the bank. It would be more of going all the way to a laughing bank!

Disclaimer!: The views expressed in this article are not that of an economist or cynic or an anti-establishment individual. The motive behind the above piece is to make ourselves conscious of the negative effects on our personal finance due to blind interest rate reduction (lending and deposits).

Mr. Finance Minister would be more prudent if he looks at making the cycle move faster by getting the common man to invest in the economy (directly as entrepreneurs and indirectly as Equity investors!). From a very aam-aadmi perspective, it would help not to affect the interest rates adversely on the small savings. People on the lower strata have only such interest on savings as an additional source of income apart from their salaries!