Dissecting the 'Interest Rate' Affair

Posted in Finance Articles, Total Reads: 508 , Published on 23 October 2015

By now, anyone who has had any connect with the world around them in the last few weeks, has probably heard and seen a lot of action surrounding the whole ‘rate’ scenario. The television channels and the newspapers were abuzz with stories talking about how everyone expects a hike in the fed rates. Closer to home, there were demands that Mr. Raghuram Rajan should cut down on the interest rates, given the current econominc and financial scenario here in India and the world over. While there are no prizes for knowing what an ‘interest rate’ actually is, it’s not so easy to link it to the plethora of financial and economic effects that it has.

Neither is it simple to understand why interest rates are suddenly so significant and how they impact each and every one of us, everyday. Let’s delve deeper and understand the developments relating to this hot topic, in India and on a global scale, along with a sneek peak into the possible impacts that these measures may have.

On the 18th of September, newspapers all over the world carried a very important news piece. This news piece announced how the the Chair of the US Federal Reserve Board, Janet Yellen, had decided to ‘hold rates’ amid expectations of a hike. In this regard, I must remind you that the USA have kept their benchmark rate around zero ever since the start of the financial meltdown in December 2008. Just to explain, the fed-rate is a sort of a benchmark interest rate that banks charge. It is actually the rate of lending funds of the Federal Reserve, from one bank to another.

Image: pixabay

This policy of keeping the rate around it’s lowest possible limit, is basically the monetary policy trying very hard to drive growth in a situation of a slow general economic growth. While the weak economic scenario and the financial concerns all over the globe have stopped the USA from hiking the rates for now, it is only a matter of time before they tighten the screws by increasing the rates. Speculations are rife that this December, the fed rates will be hiked. When that happens, the US, as a lender will basically be asking it’s borrowers to pay more interest on what they’ve borrowed. Since this list of borrowers include India, there will be a capital outflow from India. The anticipated capital outflow along with the effect of a surging dollar, will translate into a great deal of money finding it’s way out of many emerging markets, not only India. Most of these emerging markets have enough on their plate already, so they cheered the USA’s decision. The increase in fed rates, whenever that happens, will mean two things for every emerging economy. First, these countries will find it difficult to sustain their own liabilities owing to significant capital outflows and the businesses will be starved for funds and investments. Secondly, the USA has found many borrowers in governments and corporates all over the globe due to their minimal interest rates. Therefore, credit all the world is dollar heavy at the moment. So, as soon as rates increase, many of these borrowers will be unable to sustain these loans.

These effects made the anticipations of a fed-rate hike quite unwelcome. Hence, markets didn’t reflect a positive sentiment or growth during the phase when the fed-rate hike was thought be around the corner. India, like a few other countries, also benefitted from these low interest rates because of the dollar ‘carry trade’. ‘Carry trade’ is the phenomenon of borrowing a low interest rate currency and buying risk assets. A considerable amount of Indian equities and debts were bought by FIIs, armed with these low fed-rates. This buying facilitates liquidity in emerging markets. Thus, a hike would hit not only cause capital outflow, lesser funds and weightier loans, but also impact liquidity. The hike would have impacted currencies and current accounts negatively. India, in this regard is in a reasonably good position with strong foreign currency reserves, a safe current account situation and positive growth prospects. As a result, when the fed rates were held this time around, the markets responded positively. All these reasons fairly sum up why the US fed rate anticipations had everyone guessing and why it was so important. But there’s one problem in all of this- the fed rate hike is still impending, when we could have just got it done and over with.

More recently, the interest rate game has been playing out in our very own country. The RBI finally decided to cut rates after being defiant towards demands of a rate cut for some time. By doing this, the RBI has been able to fend off the impacts of the global slide, atleast in the short run and positively impact investments, growth, consumption and appeal to foreign investors, all at once. The Indian markets reacted instantaneously and rallied up 700 points before the growth was stalled for the day. The Indian markets still closed up, when all other Asian markets tumbled. All this is well justified, considering Mr. Rajan’s pre-Diwali present , a significant 50-basis point cut rather than a more anticipated 25-basis point cut. There are many reasons as to why the RBI decided to take this step at this point of time.The inflation forecasts have been lowered and so has the expected growth rate. Moreover, the global slowdown is not getting any better with every passing day and the industry is facing problems of excess capacity in the face of the slowdown and lack of demand.

There are many ways in which these measures will impact Indian markets and the financial & economic scenario, but let’s first discuss the five most direct and major impacts. First of all, floating rate mortgages of all types, including home loans, car loans, personal loans etc. will now need you and me to bear lesser interest expenses. This will increase the demand of these loan products and this will obviously have a positive chain reaction on the economy. Secondly, as the borrowing rates fall, banks want to reduce the interest rates associated with CASA deposits. So, money markets will see a fall in rates. Thirdly, the equity markets will be positively impacted in more than one way. First of all, smaller interest rates will mean a more postive consumption behaviour and this will in turn help pull up the topline. Also, lower interest expenses will mean greater profits. Also, money will show a tendency to move from the now less rewarding debt market to the equity market. The fourth impact will be on currency. The Rupee might depreciation slightly, as is the case every time there’s a rate cut. This will make importing slightly more difficult while exporters stand to gain. Finally, the domestic economy stands to gain if the corporates decide to invest more in the government, since it’s more viable to do business and set-up capacity in times of lower interest rates. However, to ensure significantly improved investments from corporates, the Government will need to work on a few policy issues too. This will make it easier for the corporates to do business with the government.

There are other important decisions that the RBI has taken. The most important ones include- allowance for easier and greater foreign portfolio investing to ensure greater flow of capital into India. This inflow can be ensure India has a buffer to deal with the outflow that’ll happen whenever the USA decided to hike it’s rates. The RBI has also lowere the risk weight associated with home loans. This means that banks can afford to give cheaper loans for affordable housing schemes. The introduction of a concept paper for greater acceptance of cards in smaller cities and towns has been proposed. This will boost the amount of electronic payments in the country. An improvement in the method of base rate calculation has been proposed. This is aimed at more effective and immediate transmission of rate cuts to borrowers. The banks must also mark to the markets, a greater portion of the bonds they hold. This is good news for banks and consumers since the banks need to hold lesser government bonds mandatorily.This means greater lending ability.

Lastly, an improvement in a very important risk management measure has been proposed. Indian entities use over-the-counter derivatives to hedge their exposure to foreign exchange. Now, these entities can hedge, not upto $250,000 but upto $1m without documents. This reduces risk from foreign currency fluctuations to a greater extent and allows for greater liquidity. These measures are all very well thought out. They promise positive growth for India and greater financial stability even in troubled times. This dizzying array of economic and financial impacts, can all be owed to a simple set of numbers known as the ‘interest rate’ or simply, ‘rate’. Now one begins to understands why all the fuss around it is so justified!

This article has been authored by INDRONEEL DAS from IIM Indore


1) Various issues of The Business Standard (from 18th Sep’15 to 30th Sep’15)

2) http://www.cnbc.com/2015/09/15/when-the-fed-raises-rates-heres-what-happens.html

3) http://www.livemint.com/Money/9v9qls0M0V9wRmpgaaJ7OI/US-Federal-Reserve-rate-hike-affect-capital-market-liquidity.html

4) The TOI (30th Sep’15 issue)


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