Interest Rates and the Indian Economy

Why RBI Interest Rates affect your loan EMI & credit cards bills?

Everytime RBI modifies the interest rate, it puts into motion the levers and pulleys of the economy. This move has impact on household savings, lending, stock markets, bond markets, capital expansion and the general state of the economy. In this post, we shall examine the implications of RBI interest rate changes on these essential cogs of the economy.

Here’s where it all starts.

Monetary Policy Committee of the RBI

The Reserve Bank of India’s Monetary Policy Committee (MPC) decides on India’s monetary policy. These are done over committee meetings which are held atleast once a quarter. The meetings are widely anticipated as it gives Indian and foreign investors an indication of how India’s Central Bank views the shape of the economy. RBI also mildly speculates on it’s future stance on interest rates which have impact on bond pricing.

Six such meetings are scheduled for FY2019-20. The first of such meetings was held on April 2, 2019. The top highlight of this meeting was the MPC’s decision to slash interest rates from 6.25% to 6.00%. The reduction in interest rate was aimed at boosting lending growth and bolstering consumer & investor sentiments ahead of the elections.

OK. What happened next?

As a consequence, the BSE Sensex recorded all-time highs and breached the 39,000 points mark. The stock market jump had an element of speculation as it involved the expectation of another rate cut from the committee in their June 2019 or August 2019 meetings.

A take-away from the MPC meeting included the RBI’s neutral stance on interest rate changes. The neutral stand indicates a measured caution over monsoons and inflation forecasts over the next two quarters. RBI’s comfort with current inflation levels was the promising part of this meeting.

Importance of Interest Rates

Investors, funds managers and the financial media are consumed by interest rates. And for good reason. The Central Bank’s direction with interest rates has a ripple effect across the entire economy. The macro areas impacted by interest rate changes include –

  1. Stock markets
  2. Bond markets
  3. Consumer spending
  4. Business spending
  5. Inflation
  6. Foreign investment
  7. Currency exchange value
  8. Real estate value
  9. Overall state of the economy

Retail investors put their money in the stock market (via direct equities or mutual funds) or buy bonds or debt mutual funds. Investors need to understand the implications of these interest rates.

In this blog post, we shall see how interest rate affect different elements of the economy. Further I will help you take better decisions by understanding how interest rate changes impact your current portfolio. Finally, let’s look at the sectors & stocks one can invest in or divest from due to these changes.

What are Interest Rates?

The term “interest rate” is widely used to define a particular rate which is set by the RBI (Reserve Bank of India). The RBI is constantly evolving the methodology of calculating interest rates given the rapid changes happening in our economies.

Let’s have a quick history lesson.

In India, this interest rate used to be the Prime Lending Rate (PLR) which gave way to the Base Rate in 2010. The base rate further gave way to the Marginal Cost of Funds-based Lending Rate (MCLR). Currently, there are plans with the RBI to replace the MCLR with yet another an external benchmark. This new move is aimed at fixing interest rates for retail loans by banks. This move was widely expected to happen in their April 2019 meeting but got the decision on that got postponed due to logistical challenges.

My article on the history of interest rates in India makes for an excellent read where I have mapped the journey of how the RBI evolved this critical economic variable through the years.

I understood. Is this how it works elsewhere around the world?

Other Central Banks use different definitions & nomenclature for interest rate.

The most watched interest rate is without doubt the one set by the Federal Reserve in the United States. In popular parlance, the interest rate is referred to as the “Fed interest rate” or Federal Reserve Interest Rate. It forms the basis against which a number of other developed economies set their interest rate. The interest rates set by different countries have a bearing on inter-country trade and commerce.

How RBI determines Interest Rates

The RBI has targeted an inflation of 4%. Inflation becomes a primary benchmark in monetary policy decisions. The RBI monitors inflation indicators regularly and when the inflation goes above the 4%, the RBI alerts all market participant with a possibility of rate controls.

Inflation in India dipped below the 4% mark in August 2018 and has remained there since. This allowed room for the RBI to reduce the repo rate. They reduced repo twice – in February 2019 and in April 2019 by 25 bps each. The repo rate is now at 6% (as on 24 April 2019). This means the RBI is in an accommodative state and is ready to give its support to growth initiatives.

Inflation rate in India in 2018 and 2019
Inflation rate in India in 2018 and 2019

When interest rates change, there are real-world consequences in the way that consumers and businesses can access credit.

Watch the video below for an understanding of how changes in interest rates affects the economy.

Video: How are Interest Rates Determined

Impact of RBI interest rates on the economy

A rise in interest rates leads to the following conditions in the economy –

  1. Increase in the cost of funds for banks i.e. the rate at which banks can lend to businesses and consumers
  2. Since the rate has increased, business are less likely to obtain loans for expanding their business or capital expenditure. Similarly consumers will not buy products like television sets or laptops as credit has become more expensive
  3. As a result, the companies that make these equipments or consumer durables will not be able to sell their products. This will create a minor recession in the market which will drive prices down and quell inflation

The RBI’s primary objective of increasing interest rates is bringing down inflation and suppress asset bubbles

On the other hand, a fall in interest rates has the following impact on the economy & its constituents –

  1. Reduces the cost of funds for banks meaning businesses can obtain loans for expansion at lower interest. This allows for more economic activity and higher profitability
  2. Similarly consumers are more likely to purchase goods, assets, houses, cars and other items as credit is more accessible and interest payments are low

The RBI’s primary objective of dropping interest rates is spurring economic growth, capital expenditure and creation of jobs.

This next section examines the impact of interest rates on some financial instruments that we, as consumers, use.

Impact of RBI Interest Rates on Key Financial Products

Credit Cards

An increase in policy rate generally increases the credit card interest rate. While not a common practice in India, credit card interest rates in most countries are variable. The credit card interests in those countries depends on the prime rate and is called variable interest rate.

Hmm .. let’s understand this with an example.

The APR (annual percentage rate) on a variable interest rate credit card might be “prime plus 10%”. So, if the prime rate is 6%, then the credit card adds it’s “spread” (i.e. 10%) on top of this 6% and seeks an APR of 16%.

The spread is the cost determined by the credit card company which’ll cover its expenses. These expenses include delinquencies, operating costs, collection costs and opportunity cost of deploying the capital elsewhere.

In case of fixed interest rate credit cards, any change in interest rates requires the credit card companies to give intimate its customers. However in variable interest rate, there is no advance notice or intimation required. Here, the consumers are expected to have an idea of the prime rate (which is generally headline news).

However, any such increase does not necessarily mean higher profit for credit card companies. Credit cards are an expensive form of credit with rates going as as high as 3.5% per month or 42% per annum. If this rate were to get higher then consumers might shun credit cards and opt for a personal loan instead.

Fixed Deposits and Liquid Funds

Increase in interest rates leads to increase in the interest rates earned on fixed deposits. Returns on other money market instruments like liquid funds also improves.

A rise in interest rate helps households who have their savings in debt income instruments like fixed deposit or short term money market instruments. However, if a part of your savings or income goes in payment of EMIs or other loan instalments, then there would be an increase in those outgoes.

Liquid mutual funds in India achieved high returns all through 2018. This was due to high interest rate regime and then a liquidity crunch in the second half of year. 2019 has not been a good year for liquid funds with the RBI reducing the repo rate & defining stricter rules.

National Debt

A hike in interest rates increases the borrowing costs of the Indian government. This balloons the national debt of the country.

The 8th Edition of the Status Paper on Government Debt released some data in January 2019. Per the paper, the total liabilities of the Central government of India stood at ₹82,03,253 crores (USD 1.17 trillion). This equates to 71% of the GDP.

India's growing national debt from 2014 to 2018. Projections made until 2024
India’s growing national debt from 2014 to 2018. Projections made until 2024

In the case of the United States, the public debt is a whopping $18.087 trillion. The annual interest outgo of the United States government is $479 billion. In other words, the interest outgo of the United States alone is over 40% of the public debt of India!

In the long run, a heavy debt burden becomes a problem not only for the government but for everyone. The World Bank has a fancy word for it – the “tipping point” – which is the moment whenthe debt-to-GDP ratio approaches or exceeds 77%.

So .. how does a government reduce debt?

There are four ways by which governments can reduce debt –

  1. Lower interest rates
  2. Increase tax revenues (the flipside of increasing tax revenue is that they slow growth & voters reject politicians who raise taxes)
  3. Cut spending (another political suicide; no politician wants to reduce spending on his dime)
  4. Shift spending to job creation activities and maximize economic growth. This means reducing expenditure on defence, education, healthcare etc. and focus on creating jobs.

Home Loans (Mortgage)

Even the indication of a rate hike builds urgency amongst home loan borrowers. They want to close the deal quickly and take a fixed loan rate (not variable) on a new home. Now, mortgages are generally variable and your home loan interest rates will travel in the direction of interest rates.

At the time of writing this article, the State Bank of India was offering the following mortgage rates –

  • For Salaried Individuals : 1Y MCLR + 15 bps (8.65%) *
  • For Self-employed Individuals : 1Y MCLR + 30 bps (8.80%) *

* The above rates are applicable for loans less than ₹30,00,000 and if LTV sought is less than 80%. LTV stands for loan-to-value i.e. amount of loan sought as percentage of value of property. Further SBI gives an an additional 5 bps relief if the applicant is a woman. Access the updated SBI home loan information from their website

Business Profits

A rise in interest rates is not good news for the business sector as it increases their cost of credit. Not only new business loans get expensive for them, refinancing existing loans also get dearer. This has a big impact in profitability of businesses which depend on finance in the form of capital & working capital loans to keep their business running. The situation gets worse if the sector where this business participates is also facing a minor recession.

A drop in interest rates has the exact opposite effect. Businesses tend to expand during that phase when credit is cheaper. Additionally, they refinance or renegotiate the terms of existing loans which adds to their bottom line.

Additional Resources

Here are some articles you can read to get better details on financial and stock metrics