All of us are affected by interest rates.
If you plan to take a loan, a higher rate would mean a higher Equated Monthly Installment. If the interest on credit card payment increases, you will end up paying more if you carry forward your payments to the next month.
In short, it will burn a hole in your pocket.
On the other hand, if you put your money in fixed deposits or bonds, you will get a higher rate. In the past few years, interest rates have been plummeting and have hit these saving avenues.
Interest rates affect our borrowing and investing.
The finance minister recently stated that banks should not raise interest rates for productive loans this year. What he meant is that the banks should not charge a higher rate from corporate customers this year.
What about next year?
Are interest rates likely to be higher?
Interest rates set to climb
It's easy to find out which direction interest rates are headed. All you have to do is look at the deposits of banks and their loans.
According to data from the Reserve Bank of India, for the 12 months till October 28, total bank credit (money being lent) increased by Rs 2,93,643 crore, while bank deposits (money being invested in the banks) rose by Rs 2,93,483 crore.
That means that bank credit has actually gone up by more than the amount of bank deposits. How are banks managing this? By selling off their investments in government bonds to generate funds.
But obviously, if this sizzling rate of bank credit continues, banks will run short of funds and will have to raise interest rates on their deposits. They will do this to attract more people to put in more money with them.
In fact, several banks have already done so. The RBI has recently raised the ceiling on the interest that banks can pay on their NRI deposits. In fact, many banks are now facing a liquidity crunch (shortage of cash).
Also, so far, companies have been borrowing large sums of money abroad, because interest rates on foreign loans were lower and the rupee was appreciating.
Now that the rupee is depreciating and interest rates in the US have firmed up, foreign loans are no longer so attractive.
Let's say $ 1 = Rs 50
If $ 1 = Rs 45 (the rupee has appreciated, the dollar has depreciated).
If $ 1 = Rs 55 (the dollar has appreciated, the rupee has depreciated).
Now, if a corporate had to pay back $1, it would only mean Rs 45 when the rupee was appreciating. But, he will have to pay Rs 55, when the rupee is depreciating.
That means companies are likely to borrow more from banks in India, which will further put a strain on the ability of banks to fund the credit growth.
In the circumstances, banks will have no option but to raise interest rates----it's only a matter of time.
Stock market will get hit
Company profits are certainly affected by interest rates.
In fact, every study of corporate profitability in the last few years has pointed out that one of the main reasons for the substantial rise in corporate profits has been the lowering of interest rates.
Today, corporates borrow money at 8% or 9%. In the mid-nineties, they had to borrow at 18% or 19%.
Now, if interest rates begin to rise, corporate profits will not continue to grow at the same pace as earlier. This would also impact the stock market. Why?
Because the price of a stock depends on the earnings of the company. If the earnings slow down (because of higher interest rate payments), the prices of the stocks will dip and overall, the stock market will be hit.
Another reason is that if profitability is affected, dividend payments too could be hit.
And finally, all those punters who borrow to trade in the market will find that their cost of funds (interest charged) has risen. This will definitely dampen their enthusiasm.
Economic growth too gets hit
A rise in interest rates also cools down the economy.
Typically, when economic growth is very strong, as it is now, demand for goods and services rise. If the supply is not immediately forthcoming, the price of those goods and services rise. That leads to inflation.
Simple case of basic economics: if supply is less that demand, prices rise.
Take for instance, the recent reports that salaries in India have been rising the fastest in the world. That's because the economic boom has led to a huge demand for qualified people, the supply of which is less.
If interest rates rise, cost of borrowing for corporates increases, this leads to lower profits, economic activity slumps, demand cools and prices drop. And then the cycle starts all over again.
If you are thinking of taking a loan, do so now. Before the interest rates rise. Preferably, opt for a fixed interest rate loan. Go for a floating rate loan only if you feel that over the next few years, interest rates will eventually dip. Read Why a floating rate home loan is better to get a clearer perspective.
Don't lock your money in fixed return instruments now. Wait for some time. Alternatively, you could opt for floating rate investments. Here, the interest rate will automatically rise if interest rates in the economy rise.
If investing in stock market, go for companies that have strong fundamentals and which you plan to hold on to for a number of years.
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