Have you stayed away from the recent tax-free bond issues from NTPC and PFC because you felt the interest rates of 7.3-7.6 per cent were too low?
You may well regret your decision over the next 15 or 20 years. The Indian as well as global experience suggests that over the really long term, interest rates will move steadily south.
Hints from history Indian interest rates have already been on a structural downtrend over the last three decades. In the early nineties, top rated Indian companies used to pay 17-18 per cent on their bonds.
Then, commercial banks offered 12-13 per cent on their three to five-year fixed deposits. Today, top-rated companies can borrow at 8-9 per cent from the market, and banks offer 7.25-7.5 per cent on three-year deposits.
Yes, it would be easy to attribute the low rates now to the RBI’s rate-cutting spree.
What if interest rates spike to 9 per cent in the next up-cycle? If the past is any indication, they aren’t likely to.
Studying RBI data on the deposit rates of Indian banks for the last 30 years shows that domestic interest rates have seen up and down cycles just like stock prices. But in each cycle, interest rates have topped out at levels below their previous highs.
Consider these numbers. In the interest rate uptrend between 1994 and 1996, the rates offered by banks on three-year term deposits topped out at 13 per cent. The very next up-move between 2003 and 2007 ended when rates hit 9.5 per cent. And as interest rates took off again between 2009 and 2012, in the aftermath of the global credit crisis, they peaked out at 9.25 per cent.
The economics of rates
The second factor that argues for locking into high rates is that, as economies mature, their interest rates inevitably fall.
The US Fed is now grappling with near-zero interest rates, but in the early eighties, the Fed Funds rate was as high as 19 per cent. Interest rates in the US have crashed over the last three decades.
The Fed Funds Rate was at nearly 9 per cent in 1990 and at 5.25 per cent just before the credit crisis of 2008.
Most other developed economies in the world have seen their interest rates chart a similar path. In Japan, lending rates have collapsed from 8-9 per cent in the early nineties to 1 per cent now.
Economists offer two key explanations for why developing economies see their rates fall over the long term. One, the larger the economy, the safer it is perceived to be by borrowers and investors. A tiny economy has to pay global lenders a high premium to source capital, because it is seen as a risky bet. But a large economy, and one which is growing well, can get by with lower rates because lenders perceive lower risk associated with it.
Two, interest rates in any economy are a function of the number of savers relative to borrowers. In nations where the aging population exceeds the young population, savers tend to outnumber borrowers. With large savings chasing fewer lending avenues, interest rates nose-dive. The sharp fall in Japanese rates is attributed to this reason.
With a large young and working population, India is today in the opposite situation. It has far more borrowers than savers. But as the population ages over the next 20 years, the tables can turn and rates could trend lower.
Of course, the rock-bottom rates in the US and other developed economies today are also a result of policy intervention.
Recessionary conditions in the US, Japan and much of the Eurozone have prompted their central banks to slash rates to near zero and throw additional cash at the economy, by way of stimulus. But with easy money policies becoming the magic pill to resolve all crises, this is yet another source of downward pressure on rates.
Inflation targeting A third reason for Indian savers to lock into high rates for the long term lies in the RBI’s new role as an inflation-warrior.
Until recently, the RBI was tasked with multiple roles while setting monetary policy. It was expected to manage foreign exchange flows, ensure reasonable borrowing costs for both the government and the economy and tackle inflation. But the recent monetary policy framework agreed to between the RBI and the Centre, substantially changes this role.
The RBI is now expected to play inflation warrior to the exclusion of everything else and will be held accountable if it fails to keep consumer price inflation (CPI) down.
Following this, the RBI has set pretty tight targets for itself. While actual CPI inflation in the last eight years was 6-11 per cent, the central bank now hopes to rein it in at 4 per cent by 2018 and beyond. Therefore, in the long run, if the RBI’s aggressive inflation targets are achieved, there’s no way Indian interest rates can remain stuck at 8 per cent plus.
So if you are convinced that Indian rates are headed down over the next 10-20 years, there’s no reason to wait. Go on and buy up all the tax-free bonds and 10-year NSCs you can lay your hands on, while the going is still good.