Mumbai: People are effectively losing money on safe investments such as bank deposits because the inflation rate is higher than the rate of return they earn.
Indeed, real interest rates (the interest rate on an instrument less the rate of wholesale inflation) across savings instruments here have turned negative even as inflation has climbed to 11.63%, a 13-year high. This is different from what happened in 1995 (see: comparison)when inflation last breached the 11% mark. At that time, real interest rates on all savings instruments were positive.
Bankers and analysts say interest rates on savings instruments will increase further to make real interest rates positive.
A negative interest rate means that instead of growing, an individual’s savings or investments are actually shrinking. The amount paid out when these investments mature, even after factoring in quarterly, half-yearly or annual interest payments where applicable, will be worth a lot less than the original investment because it can buy a lot less of, say, food or fuel.
It isn’t as if investors have a lot of options at their disposal because the Sensex, the benchmark index of the Bombay Stock Exchange, has lost at least 35% since the beginning of the year. This means an investment of Rs1,000 on 1 January in Sensex stocks in exactly the same proportion in which they are represented in the index would now be worth Rs650.
Last week, banks raised their deposit rates by at least half a percentage point across maturities but, despite this, inflation-adjusted earnings on bank deposits for consumers remain negative as the inflation rate is rising at a faster pace. There has been no change in the interest rates on various small savings schemes run by the government.
Back in 1995, the interest rate on a one-year bank deposit was 11.5%, while the interest rate on provident fund savings, a sort of social security net for employees in the organized sector, was 12%.
The interest rate on provident fund savings has since been reduced to 8.5%.
Real costs of borrowing, lending
The real interest rate is the rate that has been adjusted to remove the effects of inflation to reflect the real earning of the borrower and the real cost of funds to the lender. It is also an indication of purchasing power derived from an investment. For instance, if the interest rate on a one-year bank deposit is 9.5% a year, and inflation is 11.63%, then the real interest rate is -2.16%. In other words, the real value of savings is actually declining by 2.16% when purchasing power is taken into account.
The actual earning is, in fact, even lower than this. This is because interest income on bank deposits above a certain level is taxable. A taxpayer who pays 30% income tax earns only 6.65% from a one-year bank deposit that offers 9.5%. Taking inflation into consideration, such investors are seeing their real value of savings declining by 4.98%.
Real interest rates remain negative for even investments in small savings schemes despite interest income from these being exempt from tax.
Provident fund revision
The Employees Provident Fund Organisation, or EPFO, that runs this social security net for employees under an Act of Parliament is considering a revision in rates. The EPFO board which met on Saturday deferred the decision on setting the interest rate for fiscal 2009. It is expected to meet again next month.
To be sure, the method of calculating the real interest rate is not exactly accurate as the inflation rate changes every week while interest rates are earned on bank deposits and small savings schemes that run for years. However, most analysts expect the inflation rate to remain high for the major part of 2008-09 and some of them say it could even rise to 13%. Moreover, inflation expectations continue to remain high despite a hike in policy rates by the Reserve Bank of India.
According to economic theory, negative real interest rates are indicative of low growth expectations and high uncertainty. Low growth expectations encourage households to save even though the return on safe assets has turned negative.
Total outstanding deposits under various savings schemes of the government in March 2008 were Rs5.31 trillion. The Indian banking system had deposits of Rs32.5 trillion as on 20 June.
1995 was different
Abheek Barua, chief economist, HDFC Bank Ltd, says the real interest rate should be calculated using the expected rate of inflation a year down the line. He adds that the entire discussion on real interest rates going negative is irrelevant. “We expect the inflation rate to moderate around 7-8% in July 2009. Hence, it will be fair to compare the inflation rate one year from now and the current deposit rates of banks,” says Barua.
Sandeep Bhandari, managing director and regional head financial markets, Standard Chartered Bank, says one should not compare today’s situation with that of 1995 as the economic scenarios are very different. He admits that the real interest rates are negative but says banks are unlikely to hike deposit rates any further as demand for credit is slowing. “The deposit rates will go up only if there is huge demand for funds,” says Bhandari. Bank credit has been growing at 26%.
With rising interest rates, the government’s borrowing cost is also going up. The yield on 10-year benchmark bond rose to its seven-year high of 9.15% on Friday. However, despite rising yields, the government’s cost of borrowing is still lower than the inflation rate. In 1995, yield on 10-year bonds was 13.99%.
According to S.S. Raghavan, head of treasury at IDBI Gilts Ltd, a primary dealer that buys and sells government bonds, there is generally a 200-250 basis points gap between bond yields and inflation. However, there are periods of negative returns and “currently we are going through that phase,” he adds. A basis point is one-hundredth of a percentage point.
Raghavan says if inflation continues to remain high, bond yields will rise further. The government plans to borrow Rs1.43 trillion from the market in 2008-09 to bridge its fiscal deficit.
So far, it has borrowed Rs56,000 crore.