The Conundrum of Low Indian Interest Rates
Why are Indian interest rates so low? And whom does it benefit? Over the last two years, the average difference between the US and India 10-year treasury yields is about 2%. This does not even cover the 3% point difference in official inflation rates –the true difference in inflation is even larger since the goods basket used by the Indian govt. does not represent the consumption basket of the typical investor.
So real interest rates in India are even lower than in the US. Can it really be that returns to capital are lower in a capital starved country like India? Not really; returns to risk capital are pretty high (I remember seeing numbers like 25% annual rates for unsecured lending). The equity risk premium is very high. Most investors are disinclined to invest in equities even with the promise of high expected returns, probably because they do not trust the corporate governance structures. So they all pile into safe government debt, and earn negative real returns.
So ordinary investors lose and those with higher risk tolerance (typically, wealthier and more savvy about financial matters) win. Also, it raises the cost of capital in the private sector and several projects do not get done. This is a hidden cost of poor corporate governance structures and the high cost of dealing with the legal system.
Over time, these will improve and the SEBI is a pretty strong regulator form all accounts. In the meanwhile, we need to reduce this cost of doing business. This is one more reason to attract foreign capital. These firms have credibility, can raise local capital at cheaper rates and increase the amount of investment . Both the amount of capital as well as vehicles to credibly deploy it are in short supply in India.
I agree with the part of real returns being negative, but honestly, as a local investor must say, that corp governance at some of the new-age companies is quite good, sometimes better than anywhere else in the world.
Sitting in Mumbai, the way I see the world around me, it seems that most Indians are culturally averse to the markets. My dad still tells me, ‘Beta, why are you ‘gambling’ by putting all your money in equities, and it kind of saddens me.
At the same time, seasoned ‘veterans’, speak of trivialities such as ‘Reliance is cheaper than ITC’, why….because reliance is at 700 odd and ITC at 1600 odd….fundamental who cares….growth who cares….earnings they dont matter….harshad and his replacement theories still at work…
My point….India is culturally averse to investment….so much so that the average householder does not not even understand equities.
As for SEBI, I dis-agree that its a strong regulator….Sameer Arora and UBS seem to be abberations…Reliance and the host of corporate questions that float around, seem to the norm. It is definitely toothless( or maybe intentless( if such a word exists in the queen’s language)).
Comment by Amitabh Iyer — August 17, 2005 @ 2:04 am
I think the low interest rates has yet another implication - in the utilisation of factors of production. In the era of low interest rates, organisations would utilise more of capital and less of labor - reason being that capital is relatively cheaper that labor.
In a labor surplus ( and capital scarce) country like India, the market signals (given my the low interest rates) would distort the usage of factors of production, leading to low growth in employment generation as compared to build-up in capital. (Yet to analyse data on that - but looks like a logical conclusion.
Comment by Ameya — August 18, 2005 @ 1:17 am
Domestically (in the US) there is normally an inverse relationship between the bond and equities markets. The equities market in India has been red hot for sometime now. Assuming the Indian equities begin to cool off, or decline and assuming their is a true market dictating allowance in the economy, yields will probably increase also. Now the long term rates have been creeping up in the US, but the equities market has basically been sideways since at least 1999 when the Dow Jones IA passed 10,000. In the US, one of the surprising (to me) aspects of the low rates was the lack of borrowing by American businesses due to concern about the broader economy. Despite historic lows in interest rates, companies resisted capital spending as well as consistenly reduced payrolls.
Comment by Brent Everett — February 1, 2006 @ 9:57 pm