Interest rates in the US, Europe, Japan and the UK are hovering near the zero level. They have remained more or less there since the 2008 US crisis. And, they are expected to remain at that level for a long time.
In India, the Reserve Bank of India (RBI) has raised policy rates 13 times since 2010 to contain inflationary pressures. The rise has been as much as 350 basis points. The rate increase cycle is obviously slowing growth.
Even retail borrowers have been talking about the adverse impact of high interest rates. But some are arguing that those who save are enjoying high interest rates. In reality, that is not correct . The nominal interest rates, you get when you invest in a bank deposit or a debenture, has moved up over two years. However, in real terms, (rate adjusted for inflation) they have not moved much.
The concept of nominal and real return is often overlooked by investors, and at a great cost. Let me illustrate this by a simple example. You have a choice of buying a car for Rs 5 lakh today or one year down the line and investing in a fixed deposit at the rate of 10 per cent.
Assuming the price of the car would fall 10 per cent to Rs 4.5 lakh at the end of one year, you would have gained Rs 50,000 by way of the interest earning in the fixed deposit. But your real gain is Rs 1 lakh — drop in car prices by Rs 50,000 and interest income of Rs 50,000. The real return, therefore, would be 20 per cent. Conversely, if the car value were to increase by Rs 1 lakh, you would have lost money if you had invested in a fixed deposit. The return on it would have been Rs 50,000.
The real return is the difference between the nominal return minus the inflation. Inflation erodes pricing power and is perhaps the most important financial strain for a consumer. Most poor people are only consumers and do not save. So, inflation hurts them the most. Most investor get lured by the nominal rate of return and do not look at real rate of return. Inflation erodes their savings silently.
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I would like to share a story of a friend who had learnt the lesson of real and nominal returns at a great expense. He wanted to buy a property in Mumbai in 2000. He parked his savings in liquid assets, as he would have needed money at any point of time to pay for the property. He came close to buying the property many times but could not close the deal for one reason or another. Sometimes the price was too high, other times he wanted to wait for some more time and so on.
In the end, property prices inflated away multiple times of his liquid assets return. While he could have bought a four-bedroom hall kitchen (BHK) flat in 2000 at around Rs 1 crore , he had to settle for a two-BHK flat in 2008 for Rs 1.81 crore. His liquid assets, post tax, returned Rs 81 lakh over eight years, but the property price quadrupled. At the end of the day, property inflation ate away half of the property.
Similarly, many investors suffer the silent killer as inflation eats away their savings kitty, by focusing on the nominal rate of return, safety of principal and surety of return. They don’t give adequate attention to the real rate of return and risk-return trade-off. My recommendation to them would be: Focus on the real rate of return.
The writer is president, corporate banking, Axis Bank
