Real interest rate dynamics: Who can help?

Availability and cost of funds are both key drivers of economic growth. The role of India’s financial sector in achieving the $5 trillion economy target is therefore critical. While financial entities will do their share of work, it’s important to understand the constraints they face in lowering the cost of funds.

Economists focus on the real rate of interest to guage the impact on growth. The cost of money has to be set off against its purchasing power. While savers prefer a higher real interest rate, borrowers want this to be low. The trick is to find the optimal real interest rate that produces desired levels of growth.

The choice of interest rate in measuring this real interest rate is critical. A good representative rate would be one at which companies and individuals borrow as it takes into account the “risk” element.

Corporate bond yields are a good proxy. Economists point out that real interest rates are high for India and hamper sustained growth. The real interest on 10-year AAA corporate bond is 1.23  per cent in the US, 1.40 per cent in China, and 5.27 per cent in India.

That’s because real interest on corporate bonds can be thought of as an amalgam of risk-free (government bond) real interest rate and risk premium. A major reason for the difference in real interest rates is the difference in risk-free real interest rates. A comparison of 10-year government securities minus inflation shows that India (3.57 per cent) has a higher rate than China (0.31 per cent ) and the US (0.02 per cent). 

This difference in risk-free real interest rates depends on how much the government borrows. Higher the fiscal burden, the higher the likely risk-free rate. According to International Monetary Fund data, the consolidated fiscal deficit is 1.4 per cent of the GDP in the UK, and 4.8 per cent in China, compared to over 6 per cent in India.

This brings us to risk premium added to real risk-free interest rate to arrive at effective real cost of borrowing. For India, risk premium on AAA bonds is 1.7 per cent to US’ 1.2 per cent and China’s 1.08 per cent. The reason this is high is because premiums represent risk and what better index of possible default than the ratio of bad loans to total. 

A comparison of gross non-performing loan percentages tells us why India’s risk premia are high. The ratio for Malaysia is 1.54 per cent, the US 1.12 per cent and the UK 0.73 per cent as against 9.98 per cent for India. So while borrowers ask for lower rates, good credit habits would help.
 

Lending and deposit rates must be seen in conjunction. Higher deposit rates set a floor to lending rates. The one-year deposit rate in India is 6.5 per cent (SBI) compared to 3.1 per cent in Malaysia, 1.75 per cent in China and 1.5 per cent in Thailand. The question is: Can deposit rates be brought down without compromising the flow of household savings into India’s financial system? Let’s remember India faces a shortage of savings. Household saving after netting out liabilities was 6.6 per cent of GDP in 2017-18 (8.1 per cent in 2015-16). 

There’s a misleading argument that Indian banks earn exorbitant margins on loans, reflected in their high net interest margins (NIMs), and have ample space to reduce lending rates. This is based on selective data where margins of a few private banks are shown to be over 3.5 per cent while that of developed markets, say the UK, is 1.7 per cent. This is comparing apples to oranges. Indian banks’ margins do not reflect provisions for credit risk, while those of the UK do. 

If we were to use the same accounting norm (from Bankscope), India’s average NIMs work out to 2.5 per cent (only 2 per cent for PSBs) for 2018, while Thailand’s was 2.9 per cent,  the Philippines’ 3.3 per cent and the US’ 3.3 per cent.

There’s a correlation between wage rates and real interest rates. The more tepid the wage growth, the  higher the real interest rate. Higher the wage growth, higher the demand and thus inflation. For developed economies, wage growth and inflation are often used interchangeably. While wage data is patchy for India, evidence shows that wage increases have been depressed and wage growth has slowed. The result is high real interest rates. Urban wage growth fell to 9 per cent and rural to under 5 per cent in 2018-19. 

The high real interest rate in India also reflects distortions in the financial economy based on regulations. The cash reserve ratio in India is at 4 per cent of net demand and time liability to Thailand’s 1 per cent and the US’ 3 per cent. Australia and the UK do not have cash reserve requirements. The notion of statutory liquidity ratio (SLR) is alien to most other economies. The comfort the regulator needs in terms of banks’ ability to access liquidity is met through the liquidity coverage ratio, so what’s the need for SLR.

Indian banks over and above corporate social responsibility undertake financial inclusion, which is imperative to meet growth and socio-economic ambitions. 

Finally, the structure of the loan and bond market plays a role in keeping rates high. First, lack of transparency in pricing loans entails a cost. This stems from a lack of defined liquid risk-free government yield curve. For most maturities, there’s no benchmark yield that can be used as a reference for pricing. This needs to be addressed to develop the corporate bond market. This would bring about division of responsibilities between corporate bond market that should fund long-term projects and banks for shorter-term financial needs. Second, the relatively high interest rates reflect the absence of risk management products such as credit default swaps. In their absence risk premium gets baked into these rates.

Finally, domestic bond, money and currency markets are interlinked among themselves and with the global markets. In order to permanently bring down cost of funds, these and associated market for hedging risks have to be woven together. The government is taking the right steps to address the issue of high cost of funds. Greater credit discipline by borrowers would help.

The writer is managing director of HDFC Bank