This is the often asked question why interest rates in India are the highest across the globe. Should it make Indians jump with glee when they see such high interest rates? The answer is really no.
Interest rates in India and across the globe are aligned to inflation. Higher the level of inflation higher would be the interest rates. Until recently, consumer price inflation was running at 9 per cent in India, though it has dipped sharply to 5 per cent recently.
In America the US Federal Reserve is targeting an inflation of 2 per cent. Banks generally offer an interest rate of a maximum of 1.25 per cent on a one year deposit. If inflation is around 1 per cent and interest rate is 1.25 per cent, you could still be better off in American deposits as the real rate of returns is still 0.25 per cent.
But, in the current situation India is far better because of the fact that CPI inflation has dropped alarmingly to 5 per cent. With banks offering interest rates of 8.5 per cent, the real rate of interest is now almost 4.5 per cent. This is perhaps the best in the world.
So, why do American companies not invest in Indian deposits?
The question then is why do American companies not invest in the debt market in India. In fact, many Foreign Portfolio Investors do invest in the Indian debt market. However, the problem for them is the currency fluctuation. If the rupee depreciates against the dollar they will lose money, which then erode almost all of the returns they get from the deposits placed in India, particularly in government debt.
For example, if the rupee depreciates 5 per cent against the dollar during the course of the year and the interest rates they receive is just 8.5 per cent then they will get a return of only 3.5 per cent. Of course, they can hedge their currency risks through the various mechanism that are available.
Interest rates in India are likely to fall further as inflation is falling. Hence it makes sense for investors to lock money in high yielding deposits today.