From UPSC perspective, the following things are important :
Prelims level : Policy rates
Mains level : Paper 3- Why interest differential could be a problem?
Do you remember Operation Twist by the RBI? what was being twisted there? It was the yield curve that was sought to be twisted. It had been aimed at reducing the gap between long term interest rates and short term policy rates. This article explains the impact such gap could have on the economy.
Why long term loans come with a higher interest rate?
- Long term loans equate to long repayment periods.
- More uncertainty during these long periods can translate to higher risks.
- And to compensate for the high risks involved, banks quote higher interest rates when corporates borrow from them to build and operate stuff.
- However, when banks borrow from the RBI they are borrowing over short intervals.
- And so they get charged lower interest rates.
So, why banks are keeping interest rates high despite borrowing at low rates from the RBI?
- Ever so often, the RBI cuts rates in the hopes of making loans more accessible to banks.
- They are hoping banks will also extend this benevolence to their customers by cutting long term interest rates.
- But right now, banks are scared.
- They don’t think the corporates can pay back.
- So they are keeping long term rates at elevated levels despite borrowing at consistently low rates from the RBI.
What happens when gap between long-term and short term interest rates widen?
- Capital wasn’t cheap to begin with for corporate borrowers, and it’s getting more expensive.
- This comes just as migrant rural workers have been driven out of urban production centers because of shuttered factories.
- Even if this labor is safely put back on, say, road construction, concessionaires [think private road contractors] might still go bankrupt before completing any projects.
- That’s because their annuity payments from the government are linked to falling short-term policy rates, whereas their long-term borrowing costs are both high and sticky
To understand the issue of annuity payment and its relation with interest rates, let’s dig deeper into 3 types of models-
1. Build-Operate-Transfer (BOT) Model
- So, NHAI is the National Highways Authority of India and is largely responsible for building and maintaining roads.
- Its preferred method to get the job done is to deploy what is called the BOT model.
- The Build-Operate-Transfer (BOT) model, as the name suggests is a way for NHAI to offload its responsibilities of road building to private contractors.
- Under BOT model, private contractors build the road, operate it, make money off of collecting toll, and after about 10–15 years, they hand over the road back to NHAI.
- There aren’t enough private contractors willing to bid for such projects because — hey, maintaining and operating a road is a pain.
- Why pain? You have to wait 15 years to recoup all the money you had to pour in to build the damn thing. That’s the pain.
2. Engineering, procurement and Construction (EPC) model
- Under the EPC (Engineering, Procurement & Construction) model, NHAI pays private contractors first, so that they can help NHAI build the road.
- The contractor does not operate or collect tolls here.
- Instead, it can walk away scot-free with money in its coffers once it’s done building the road.
- But it’s hard for the government to shore up all the resources required upfront.
3. Hybrid Annuity Model (HAM)- The middle path
- It’s a nice little mix of both EPC and BOT.
- Under it, NHAI pays some money upfront in fixed installments usually, 40% of the project cost.
- And the private contractor does his bit by putting up the rest and finishing the project.
- However, once the construction is complete, the contractor does not make money off of collecting toll.
- Instead, he transfers the assets over to NHAI.
- So its incumbent on the government to pay the rest of the money once the project takes off.
- And the payments are dependent on the asset created, the performance of the developer, and a few other things.
- However, since the payouts usually last 15–20 years we need to find a way to determine what kind of money the government pays the contractor every 6 months.
- And here’s the best way to think about this — So when the government pays the 40% upfront, it’s promising to pay the 60% sometime in the future.
- It’s money they owe the contractor.
And, here is the crux of the matter
- So when the repayments, are made, they’ll have to pay the principal and the interest.
- The interest involves a fixed component (3%) and a variable component.
- What is varible component? The variable component is effectively the short term policy rates.
- So if the RBI keeps cutting these short term rates, private contractors get less money per instalment even if their roads are all nice and shiny.
- And this can’t bode well for them because they probably put up the 60% back in the day by borrowing from another bank.
- A bank that’s charging them long term interest rates that refuse to come down.
The widening gap between the short term policy rates and long term interest could easily spell the disaster for the entrepreneurs and in turn for the economy as a whole. The government should consider a special package for such entities given the unprecedented situations we found ourselves in.