Falling interest rates: who gains, who loses?

The sharp fall in interest rates over the past two years has raised questions about who has gained the most from it. Is it the government that borrows to fund its deficit or the corporate sector that borrows both for working capital as well as fresh investment?

It turns out that over the past two years, the corporate sector (or at least a part of it) has been a bigger beneficiary than North Block. The government may often be accused of tinkering with the monetary levers to lower the cost of its borrowing binge but appears to have gained less from the fall in rates than Indian industry.

There are a number of critical and somewhat complex issues in comparing the government and the corporate sector's interest charges that need to be highlighted. For one, the quantum of debt contracted by the two entities becomes vital to the comparison of the interest burdens.

Thus, even if, say, corporate interest charges on the whole have declined more than the government, it could be simply due to the fact that it borrowed much less. So, it is important to look at not only the interest cost but also the quantum of debt on which this charge was incurred.

The measurement of debt stock itself poses a set of problems. One of the more fundamental ones relates to the fact that published balance sheet data (compliant with accounting disclosure norms) refers to the year-end stock of debt. There is no information on intra-year borrowing and repayment.

Yet these intra-year dips and spurts could make a critical difference to the magnitude of interest charges. A company (or the government) could borrow a significant amount within a year and repay the loan by the end of the year.

This would mean that while interest charges are likely to be high, year-end debt figures could be low and this could completely skew the picture. Both the government and the corporate sector borrow a fair amount of short-term funds, the former through the treasury bill route and the latter through working capital loans.

There are issues related to the tenor of borrowings that a simple comparison of absolute magnitudes of interest costs does not capture. The government's interest costs could be higher simply because it has borrowed longer term than the corporate sector (longer term debt is usually always more expensive than shorter term).

Thus, a difference in total interest payments could be explained, at least partially, by the tenor (maturity of the loan) and not by interest rate charges alone.

Given these complexities, the pertinent question to ask is: how much of the reduction in interest charges of the government and the private sector has been due to the interest rate decline alone? If it is possible to isolate this pure interest rate effect, how have they fared relative to each other in terms of this effect?

A way to do this is to look at borrowing costs directly for each tenor or loan-maturity and measure the decline in the effective interest rate for both the government and the corporate sector? This clearly takes care of both the problems related to maturity as well as those arising from measuring the debt stock.

There is another caveat here. The corporate sector is hardly a homogenous entity when it comes to borrowing costs. Different companies are charged different rates of interest given their risk profile driven by factors like the cyclicality of the industries they operate in and so on.

This heterogeneity has increased sharply with the advent of "sub-prime" lending and disintermediation. Sub-prime lending refers to bank lending at rates below the declared prime-lending rate. Disintermediation is the process by which companies borrowed increasingly directly from the market by floating debt paper.

Thus, it is essential to distinguish between the different categories of companies "" the blue-chip AAA companies, the somewhat riskier AA and the significantly riskier A category. Companies below the "A" grade typically do not have access either to sub-prime loans or the disintermediation option. For them, the prime rate is the effective reference interest rate.

A final bit on the methodology before we get to the conclusions. The government's borrowing costs are measured from the zero coupon yield curve calculated daily by the National Stock Exchange. This abstracts from the effects of differing coupon rates on different bonds and arrives at a pure yield akin to the interest rate that the government would pay if it took a loan from a bank.

Corporate borrowing rates are derived from the bond-spread matrix that gives the premium that corporate bond yields command over the risk-free Central government yields.

What does the data tell us then? Despite the sharp decline in secondary market yields, the drop in prime-lending rates has been marginal. Between 2001 and 2003, the prime-lending rate (the average of 5 major banks) declined by only 50 bps.

Thus, companies whose borrowing cost is linked to the prime rate appear to have gained the least. This would include most of the small and medium enterprises sector. The picture changes if we move to the "A" category companies. These saw a substantial decline in the past three years.

Between July 2001 and July 2002, AAA companies (the only reference category we have for the period) saw a somewhat sharper decline at the short maturities than the Central government.The government gained more for longer term debt. However, the difference in the magnitude of the declines was not very large.

The period between July 2002 and July 2003 saw a starker difference in yield declines between the government and the corporate sector. All risk categories of corporate borrowers gained more than the government and at all tenors. Within the investment grade, the riskier companies (rated A) gained the most, more than the blue-chip AAA or AA companies.

This could be due to the fact that the perception of an economic recovery was established by early 2002-2003. "A" category companies often have a cyclical revenue and profit profile that was then seen to improve. Given the fact that interest rates for these companies had moved up sharply in the previous phase of the economic downturn, there was a sharp correction in response to the change in perception.

Here's the bottom-line. The large, organised corporate sector seems to have fared better than the Central government in terms of reduction of interest rates. The recent phase of economic recovery coupled with the continuing increase in liquidity has helped the non-blue chip companies.

Small companies that borrow at rates linked to the prime-lending rates of banks have gained the least. The government has had some advantage at borrowing long term.

(Abheek Barua is a senior economist and Sonal Varma an economist at the Crisil Centre for Economic Research)