Real interest has to be positive

Negative real rates mean that the return you get on financial assets not enough to cover inflation

In my discussions with the investment community over the past 12 months, I have endlessly asked where did we go wrong in the past five years? The answers have ranged from blaming policy paralysis to global environment, bashing politicians to speculation in real estate and even gold. The answer is ‘negative real rates’. Simply put, negative real rates mean that the return you get on financial instruments is not sufficient to cover inflation. So you end up with negative real returns.

India has witnessed negative real interest rates since 2008, which has dis-incentivized savers, thereby triggering a sharp movement of household savings (70% of overall savings) from financial assets to physical assets. The proportion of household savings invested in financial assets has reduced from around 50% in 2007-08 to around 30% in 2012-13. A lot could (or already has?) go wrong in India if savers continue to be dis-incentivized and real rates continue to be negative.

India has among the world’s highest savings rate. It is, therefore, unusual for this country to run a high current account deficit or CAD (average CAD of about 4% in the past five years).

Negative real rates have triggered irrational investments in physical assets such as gold and real estate; it has promoted consumption and poor quality investments. So not only does the consumer spend unwisely, but even companies start taking up projects because the future looks optically bright where everything tangible is expected to increase in value perpetually.

To make matters worse, companies levered up to bid for and execute poorly selected projects and have ended up with balance sheet deterioration. The result is an asset price bubble, which upon bursting, will erode wealth and have contagion effects. The lure of gold is equally strong; in a perpetually depreciating domestic currency environment, gold has delivered returns above financial assets (last year was an exception).

Clearly, while we are among world’s highest savers, unfortunately, it has not really translated into productive use.

The incentive for households to invest in financial assets and the perceived real return from these assets is of utmost importance for savings to be diverted back into financial assets. The culprit here is uncontrolled inflation. Raghuram Rajan, governor, Reserve Bank of India (RBI), is a champion hawk. The 2009 report of the Committee on Financial Sector Reforms argued about how best the RBI can serve the cause of growth by focusing on controlling inflation. The Urjit Patel Committee has come out with a scathing attack on inflation: it said the central bank should target to reduce the consumer price index (CPI) to 8% by 2015, 6% by 2016 and 4% thereafter. In this context, CPI has averaged above 8% since 2005 and last printed at 8.1% in February 2014.

With most developed markets witnessing disinflation or outright deflation, they could start to catch up to our cost advantage. We can either take short-term pains for long-term gains and take the bitter pill of killing inflation to restore competitiveness, or stay stuck at 5% growth for a prolonged period.

Foreign flows

Real interest rates have to be seen in a global context because it drives capital flows among developed markets and emerging markets. Hot money flow from the former provided the latter with easy money (albeit accompanied by bond yield volatility) and excuse to avoid reforms.

However, investors’ perception has changed, with inflation in developed markets on a southward trajectory, and money flowing back to them.

Back home, Rajan has stressed the importance of long-term dollar denominated return for institutional investors in India and the importance of a stable currency in this regard. The trajectory of policy rates, therefore, can be safely predicted to be northward till inflation abates and stays put.

Another stance taken by the central bank is reluctance in conducting open market operations (OMOs). The RBI is increasingly using term repo to inject liquidity with relatively low permanence as compared to OMO liquidity to keep the banking sector liquefied at the shorter end. To my belief, this is the only and the surest way to tackle a profligate government which panicked as a response to the slowing and spent the entire surplus on the balance sheet (post-Lehman fiasco) and then callously resorted to artificially induced cheap borrowing in a negative real interest rate environment. I believe the central bank is in the process of putting an end to easy sovereign borrowing.

Investment landscape in new environment

Paul Volcker, as the chairman of the US Federal Reserve in the 1980s, was able to kill inflation by pushing up real interest rates for a prolonged period, albeit followed by recession. Make real interest positive and the investment landscape will change. Initially, real positive rates will drive savings to financial assets. Higher rates will drive out unwanted consumption and reduce currency in circulation, which will, at some point, start topping out when enough money gets diverted to financial savings.

A real bull market in equities come somewhere along the way. Since controlling inflation will take time, investors should add to their financial savings and lock it for longer maturities this year. Even short-term deposit or corporate deposit rates are expected to remain elevated for some time and investors could make use of these rates.

The writing is on the wall: days of high return in physical assets are over; and highly leveraged companies will struggle and will have to raise capital to survive in a positive real rates environment, while healthy, free cash flow generating business models will go from strength to strength.

Ritesh Jain is chief investment officer, Tata Asset Management.