I have touched upon a few basic concepts around Interest Rates in my previous articles, including what they represent, how they work, who sets them, and their role in commonly available savings & lending products (car loans, home loans, education loans, gold loans).
In this piece I will elaborate on some rather ‘layered’ issues around Interest Rates in a Q&A format. Kicking off with a few questions from my end to get the ball rolling.
Feel free to add your queries in the Comments section below which I will try to respond through future articles.
1. Do Interest Rates Change?
My Finance Professor used to say that the best answer to a complicated question is:
Depends on what?
Well, what time frame are you looking at? Secondly, what type of Interest Rate are you talking about?
As explained earlier, ‘Interest Rates’ as a standalone term, let’s just say, is rather non-specific. It can refer to a wide variety of things, be it i) Retail-level Interest Rates which people encounter when transacting with their local bank either as savers or borrowers, ii) Short-term Interest Rates set by the country’s Central Bank e.g. repo rate adjustments by RBI in India, or iii) Benchmark Long-term Interest Rates derived from the issuance and trading of government bonds.
Best way to answer this question would be to go point by point:
i) Retail-level Interest Rates
In a short to medium term period, Retail-level rates are the most stable as they’re derived rates instead of benchmark rates, as in category ii) and iii).
Your bank effectively collects money from depositors (paying them some interest i.e. the savings rate) and lends money to borrowers (charging them some interest i.e. the loan rate).
Naturally, frequent changes in your savings rate or regular modifications in your car loan EMI are not desirable. Think of the challenges it will pose to your financial planning! Hence banks don’t do that. Once they’ve advanced a loan, they will ensure your EMIs stay the same (unless you take a Floating Interest Rate loan as discussed earlier) through the duration of the loan.
However, Interest Rate on a ‘new loan’ (which gets locked once the loan is advanced) would vary as per the latest translation of the Central Bank’s view.
Savings rates are also periodically revised (once a quarter or sometimes more frequently) depending on a bank’s commercial considerations within the broader economic agenda set by the Central Bank.
ii) Short-term Interest Rates as set by the Central Bank
Central Bankers meet frequently (e.g. the RBI meets once in 2 months) over what they call a Monetary Policy Review.
The objective of this review is to flex short-term Interest Rates (e.g. repo rates). Repo rate in layman terms is the Interest Rate charged by the RBI when a commercial bank borrows funds from it. This borrowing is a frequent activity, and a lot more frequent during a liquidity crunch.
Hence the RBI can promptly vary the supply of money in the Economy by changing repo rates (e.g. to control inflation). We will cover this concept in more detail when talk about Monetary Policy at a later stage, but the important thing to know is that once every 2 months, the RBI’s repo rate is up for revision, either an increase, a decrease, or a hold (i.e. no change).
This rate is important as it sets the tone for short-term Interest Rates in the country and is hence often used as a benchmark for commercial banks to setup the Retail-level Interest Rates discussed earlier, either as Interest Rates on a ‘new loan’ or as part of their Savings rate review.
iii) Benchmark Long-term Interest Rates derived from the Issuance and Trading of Government Bonds
They vary all the time, by the day, by the hour, by the second.
This is because they are supply and demand driven. And economic forces move the market’s demand for government bonds.
Higher is the demand for a new government bond issuance, lower would be the offered Interest Rate. Lower is the demand, higher would be the offered Interest Rate to attract investors. This demand combined with the perception of risk keeps changing.
If the world is hit by a global financial crisis, benchmark rates of most countries would go up. When President Trump slaps import tariffs on China, rates in China would increase. If the government’s fiscal deficit is widening, rates would increase…as that implies the government is spending way higher than it can fund.
2. Why are Retail-level Interest Rates comparatively stable, but Benchmark Long-term Interest Rates much more volatile?
Think of electricity you get in your house. How is this flowing to your room? There is perhaps a coal or gas power plant outside your city where bulk electricity is being generated. That high voltage current then travels across transmission lines to your city. Once it reaches the city, the voltage is stepped down and the current moves along distribution lines towards your neighborhood and home.
Now the biggest input cost for the power plant would be coal. Coal’s price is supply-demand driven and is hence volatile. Do you get a higher electricity bill every time coal prices go up?
I guess not.
The utility company ensures the rate at which they’re charging you doesn’t sway as per the changing tides of the coal market.
When it comes to Interest Rates, think of Retail-level Interest Rates analogous to your monthly electricity bill, and the Benchmark Long-term Interest Rates as the volatile price of coal. The former is stable, the latter volatile.
3. Why are the Interest Rates charged by the Bank on Loans higher than the Interest Rates the Bank pays back on Savings accounts?
Well, this is pretty much the business model of banks. As explained earlier and in ultra-simplistic terms, banks collect deposits from deposit holders (i.e. the savers or let’s just say the regular folk).
These deposits are then given out as loans to borrowers. How does the bank make money?
It pays some interest to the deposit holders and charges a higher interest from borrowers. The interest on loans is naturally higher than the interest on deposits for the bank to make any profit.
4. Why are Interest Rates higher in India vs. the Developed world?
Interest Rate is a measure of risk and credit worthiness. The risk of investing is perceived to be higher in a developing country such as India vs. the developed world. It’s a question of many factors, such as regional stability, state of government finances, robustness of currency, availability of legal recourse in case of default or bankruptcy etc.
Developed economies, being more diversified and mature, are comparatively better hedged against these contingencies.
Secondly, Interest Rates trail inflation. Inflation can be understood as the rate at which value of money depreciates (more on Time Value of Money later).
e.g. If I could buy 200ml of toned milk last year for INR15, but I now need to shell out INR16 to buy the same 200ml of toned milk, the value of money in a way has depreciated. The Interest Rate I can earn by depositing money in the bank has to be at least higher than the rate of inflation.
Developing countries in general have a higher inflation rate (owing to higher demand plus other structural drivers) and hence require a higher Interest Rate. Clear?
Thirdly, its about access to capital. More is the availability of capital to lend or invest, lower should be the cost of borrowing (the magic of supply and demand). Developed countries are bigger financial centers, have massive capital inflows and hence have lower rates of interest. Developing countries are relatively scarce in capital, hence a higher rate of interest prevails.
For a deeper understanding of Interest Rates and how they work, you could refer to my previous articles below:
This will be a recurring column published every Friday under the title: “How to Make Sense of the Indian Economy”.