Interest Rate Mechanism

Interest rates reflect the price of money/credit in the economy. Banks have two main sources of income - the net interest income (i.e. income earned on loans minus payout on deposits) and the incomes they make on their investment portfolios. Since bond prices move inversely with interest rates and the bulk of banks' portfolios is in bonds, treasury incomes rise with a fall in interest rates and vice versa. However, the bank profits largely depend on their net interest incomes.

The key interest rate indicator, also known as the REPO rate has recently been lowered by 100 basis points by RBI. Repo rate is the annualised interest rate at which banks borrow money from the Reserve Bank of India (RBI) over a short term. At the same time RBI has lowered the reverse repo rate by 100 basis points, signalling the banks to cut their lending/ deposit rates. Falling interest rates are a boon for the borrowers in the long run, as they help sustain the profitability of the companies.

The recent rally in the global/Indian markets is a reflection of the fact that the markets believe that the profitability of the companies is going to improve with the steps taken by the monetary authorities recently. But we need to consider the under noted facts:

• Are these measures enough to revive the economic activity and the consequent demand for companies' products. The falling incomes and the uncertain environment are forcing the consumers to postpone their purchases.
• Are banks in a position to pass on the benefits to the end users. Unfortunately banks in India cannot lower the interest rates drastically, because of the administered interest rates of the small savings schemes which directly compete with bank deposits.

Keeping in view the above factors the falling interest rates may not have a significance on the revival of company fortunes for at least the next two quarters. This fact makes me believe that the rally in global markets may not sustain long enough.