A V Rajwade: Interest rates and equity investment

WORLD MONEY

There was some talk in the debt market a couple of weeks ago that the provisions of the Fiscal Responsibility and Budget Management Act, 2003, may lead to higher rates of interest.

The rationale was that since the act bars the Reserve Bank of India from subscribing to primary issues of G-Secs after 2005-06, they would need to be sold in the market putting upward pressure on yields.

Such speculation, however, seems to be unwarranted. The Act specifically provides for secondary market operations.

One would assume, therefore, that the ability of the Central bank to maintain the desired level of money supply would not be impaired by the provisions of the Act. And in the final analysis, money supply will determine market interest rates.

To my mind, a more relevant question is whether "real", that is, inflation-adjusted rates of interests are too low. C Rangarajan, the chairman of the Economic Advisory Council, seems to feel so as some of his public speeches evidence.

In a major address, delivered in Pune last month, he discussed the subject at length, also in the context of the Sukhamoy Chakravarty Committee Report.

While no specific numbers were spelt out, he argued that the "real interest rate should be kept at a level necessary to generate savings and investment that are needed to support rapid economic growth."

The statement raises several questions in the mind of a student of financial markets like me. The issues are:

On first principles, higher interest rates should lead to higher savings, but may simultaneously act as disincentives for investment. Can real interest rates be so calibrated as to support both savings and investments in an optimum fashion?

The difficulty is perhaps even more pronounced when you look at the lags between investment decisions and the actual need of money to finance them;

More interestingly, is there a strong correlation between high real interest rates and savings at all? Last year, for instance, the general level of interest rate was quite low in both nominal and real terms, but this has not reduced the savings of the household sector "" indeed, they have gone up as a percentage of the income!

I have also seen empirical studies made in a bank that evidenced little correlation between the level of interest rates and deposit growth;

Indeed, it could even be argued that, given the current scale of fiscal imbalance, high interest rates could well have reduced national savings by increasing the dissavings of the government in the form of the fiscal deficit.

Surely, last year's high national savings rate (28.1 per cent) was bolstered by lower dissavings of the government, at least some of which can be attributed to lower interest rates.

On the other hand, the low yields on government paper clearly have caused problems to provident funds in paying the promised high returns. The government has agreed to a 9.5 per cent return, bowing to pressure from the Left and the trade unions.

Reports indicate that this will lead to a shortfall of Rs 1,000 crore between the interest liability of the Employees' Provident Fund Office (EPFO) and its current income.

Even after adjusting some old surplus, a gap still remains, and will grow. The government seems to have taken a stand that it will not subsidise the gap "" some time back, the prime minister has said that he would not like the EPFO to become another US64, requiring a bailout by the government.

The subsequent rise in the value of the equity portfolio of US64 taken over by the government, thanks to the stock market reaching to new heights, to my mind, does not justify the original sin "" namely placing quasi-guaranteed income liabilities in the equity market.

And yet, this is exactly what we seem to be doing in relation to both the provident funds and commercial banks by permitting higher exposure to equity markets.

Equities are riskier investments than debt and are supposed to give a higher return "over the long-term". This is by no means certain, in any case not at a given point of time.

Equity markets are known to have given low to negative returns for extended periods of time and to me at least, encouraging the assumption of higher risks to pay unrealistically high guaranteed returns (9.5 per cent) does not seem to be a prudent measure.

As it is, reports convey that the EPFO has invested in low quality PSU bonds (they alone probably give the desired return) and is facing defaults.

The appointment of big name advisers (Mercer Human Resource Consulting) cannot reduce the even higher risks in equity investments. The 9.5 per cent return is, of course, the holy cow.

Turning to commercial banks, one of them has been allowed to take exposure up to 8 per cent of assets in equity markets. Others are sure to follow.

Is this a prudent practice? The experience of Japanese banks, which traditionally had high exposure to both real estate and equity markets, amply evidences the risks.

At last count, the bailout of the Japanese banking industry had cost the government hundreds of billions of dollars!

In any case, surely a distinction needs to be made in terms of the capital adequacy ratio for direct and indirect exposures to the equity market?

If loans secured by equities attract the normal credit risk capital, surely the capital charge for direct exposure to equities should be based on market risk principles?

Email: avrco@vsnl.com