Real Interest Rates in India Amongst the Highest in the World Right Now

In the wake of yesterday’s Monetary Policy Review meeting, it’s important to talk about real interest rates in India. 

What is Real Interest Rate? 

Real interest rate = Nominal interest rate - Inflation 

For example, if you earn 10% (this is the nominal interest rate) on a deposit with a bank and inflation is running at 8%, the real interest rate you earn = 10% - 8% = 2%. 

What does it mean? 

If your deposit is worth Rs 100, the interest you earn is 10% * 100 = Rs 10. But inflation is running at 8% which means that whatever goods you were buying earlier with the deposit mount (Rs 100), now cost Rs 108. So, of the interest income of Rs 10 (or 10%), Rs 8 (or 8%) goes just in preserving the purchasing power of your deposit. Your “real interest income” is Rs 10 - Rs 8 = Rs 2 or 2%. This is the income with which you can buy extra goods over and above what you could buy with Rs 100 earlier. 

So the “Real interest rate” gives you (the lender), the true purchasing power of the interest income you earn. For the borrower (the bank in this case), the “real interest rate” is the return it gives to the lender in terms of real purchasing power. Naturally, it follows that....

....High Real Interest Rates are good for lenders and bad for borrowers 

Even after yesterday’s Repo rate cut, Real interest rates in India are amongst the highest in the world right now 

Let’s compare current Real interest rates in India vs. those in the US. For this purpose, we will compare the Real interest rate on 10-year government bonds of both countries. Government bonds give us the “risk free” real interest rate for a country because theoretically, governments do not default on their debt. At least that is the expectation. 

Real interest rates on corporate bonds are higher because over and above the risk-free real interest rate that is associated with government bonds of the same maturity, lenders add a risk premium to compensate for risk of default by the corporate entity. 

The 10-year government security (gsec) yield in India yesterday (2nd Aug) was 6.46%. The most recently reported CPI inflation number (for June) was 1.54%. This means that real yield or the “real interest rate” for the 10 year gsec is 6.46% - 1.54% = 4.93%.

In the US, 10 year g-sec real yield (on 2nd Aug) was 0.47%. 

As you can see, the positive differential between the 10-year Real interest rate in India vs. the US is a whopping 4.45% or 445 bps! India currently has one of the highest real interest rates in the world, making it a rather lucrative destination for foreign funds looking to pick up this extra yield. 

This is the reason that FII/FPI funds have been pouring into the Indian debt market 

Year to date, FII/FPIs have ploughed Rs 1.71 lakh crore ($27 Bn*) into the Indian equity and debt markets. Of this total amount, Rs 1.15 lakh crore ($18 Bn*) or 67% has been invested in the debt market and Rs 56 lakh crore ($9 Bn*) or 33% has been invested in equities. 

As one would expect, Indian debt has absorbed the lion’s share of foreign fund inflows YTD.

* I’ve converted FII/FPI INR inflow figures into USD at the 2nd Aug exchange rate of INR 63.635/USD.

While these high Real interest rates are favourable for FIIs/FPIs (foreign lenders), they are bad for Indian industry (borrowers) as explained above. That said, simply lowering rates isn’t a magic bullet. 

Especially in the current environment where demand is muted, corporate earnings aren’t strong, corporate balance sheets are over-leveraged and the NPA problem is rampant, corporates aren’t borrowing much anyway. High real interest rates on top of that, aren’t helping. This is one of the key reasons why market players wanted a lower Repo rate and applauded RBI’s rate cut yesterday. 

It’s important to remember however, that simply lowering rates is not going to revitalize India Inc. For that to happen, demand has to pick up, the investment cycle has to start in earnest, over-leveraged balance sheets have to be stabilized and the NPA issue has to be fully dealt with. 

Finally, let’s look at some historical data. 

Another way of calculating Real interest rates is looking at the spread between the Repo rate (the rate at which the RBI lends to commercial banks overnight) and CPI inflation. This gives us the “real interest rate” for overnight funds. 

In the chart below, I have plotted CPI inflation, Repo rate and Real interest rate (Repo rate - CPI inflation). For July and Aug ’17, I’ve assumed CPI inflation of 1.07% and 1.45% (there’s a favourable base effect) respectively. This gives us estimated real interest rates of 5.18% for July and 4.55% for August.

As you can see from the chart below, besides Nov ’14 when the real interest rate rose to 4.73%, current real rates are the highest that we’ve seen since Jan ’12. 

Barring Nov ’14, current Real rates are the highest we’ve seen since Jan 2012.

Source: RBI, MOSPI data