Real and Nominal Rate

[A380]

Fin. Institutes offers profits on investment at specified rates. It is in practice that these rates are the nominal rates and not the real rates of return. I would like anybody to explain how can we convert nominal rate to real rate. Practical example req.?

Regards
Asad

[Schuaeb]

Nominal rate - Infaltion = Real rate

[msc286]

@ Schuaeb

So if a bank is offering a return of 10% on deposits, would it be the real rate or nominal rate?

[kamranACA]

Yes off course, this is nominal rate.

If a bank is offering 10 percent rate, it represents a portion of inflation included there in.

Inflation do affect SBP base rates as well as lending bank's spread. More the inflation would be in the ecnonomy, more would be the nominal interest rate.

However, there appears practical problem specifically in the countries like Pakistan. For example inflation is normally reported at 10 percent plus in our economy. If inflation is 10 percent then how the interest rate could revolve round about at 14 percent to 15 percent? I know SBP normally shows its aims to curtail inflation below 5 percent and makes similar announcements but practically it does not happen.

I dont know what exactly the current inflation rate is at Pakistan. However, it appears that there remains some timing gap.

As per formula, NOMINAL INTEREST RATE - INFLATION RATE = REAL INTEREST RATE

Nominal interest rate normally includes

- SBP's return;
- Effect of inflation on SBP base rate;
- Lending bank's spread;
- Effect of inflation on lending bank's spread.

This composition shows that in practical the nominal rate might not work back to real rate exactly.

I need comments of other members on this scenario.

Best regards,

Kamran.

[Schuaeb]

This composition shows that in practical the nominal rate might not work back to real rate exactly.

How?

[A380]

WHat do u mean by SBP's return
Can u explain in brief "Lending bank's spread"
Also bank states KIBOR + X bps agreements. What is bps?

[kamranACA]

Dear Shoaib,

I mean to say that if SBP rate (base rate) is almost 10 to 12 percent and the lending bank also includes 2 percent spread in the base rate and thereafter nominal interest rate is charged to the customer at 14 percent then where does inflation go.

In my view, it is embedded in the SBP's rate and the spread of the lending bank. It cannot be separately identified unless the SBP and lending banks disclose their real interest rates and inflation factor embedded there-in.

[kamranACA]

Fixed interest rate financing is prohibited by SBP regulations. Therefore, interest rate has to be the fluctuating rate. It is normally composed of some basic rate of banking market like LIBOR (London's Interbank Rate) or KIBOR (Karachi Interbank rates). This basic banking market rate depict the bank's average cost of financing. The banks add their spread (profit margin) to such basic rates for ensuring a return against the finances arranged by them for their customers.

SBP return meant the SBP's rate which it charges to the lending banks. Normally lending banks arrange their financing from SBP. SBP declares a basic bank rate which is meant for charging to the banks by SBP.

Lending bank's spread means the profit margin added as a percentage by a bank to SBP's basic bank rate for ensuring a return to the bank involved with the ultimate customer.

KIBOR + bps agreements. BPS stands for reflecting basic points in terms of percentage.

For example if interest rate is mentioned as KIBOR+ 250 BPS, it would mean that interest rate is KIBOR+2.50%.

Likewise KIBOR+200bps means KIBOR+2%.

Regards,

[Schuaeb]

(I try to produce things in simple form and may be I'm subject to som basic mis conceptions)

A bank borrows money from state bank or other commercial banks at KIBOR. Plus the deposit with the bank comprises the money that is to be lent by the bank. The state bank in pursuit with its monetary policy aims determines KIBOR. So, KIBOR is the lending cost of the lending bank. It adds its spread (which is also determined in accordance with state bank's policies) to the KIBOR and lends money at that rate. The interest rate on financing offer letters is generally mentioned as KIBOR + 2%. So, this 2% is basically the main source of income for the bank.

Now what is nominal rate? It is KIBOR plus the percentage added by the bank. For instance we say that KIBOR is 10%, lending banks spread is 4% and inflation is 8 %.

Now nominal rate is 14% and real rate is 6%. (The concept of bps was useful addition to my knowledge)

Another important point is, the difference between the percentages at which banks are lending money and that the give to depositors. Despite claiming record-breaking profits and sbp's warnings no reduction in this gap is seen. I wonder what sbp is relying of giving warnings and not directly taking action.

[msc286]

Very useful discussion indeed.

Recently there was hue and cry from many sectors regarding the interest on the deposits paid to the account holders. Generally now a days banks are lending at the rate of 13% to 18% (off course depending on who is borrowing the money) and on the other hand the maximum return to the deposit holders is about 11% (and that too on long term deposits). I think the average rate is 8% to 9%.

SBP should initiate some concrete steps to narrow the gap.

[kamranACA]

Dear Shoaib,

Yes what you have written is correct.

I also conclude that the inflation factor is embedded in KIBOR as well as bank's spread and cannot be separately identified.

I just quote one example. Last days, there was a big debate that Pakistan's inflation has crossed 10 percent and was claimed to be at 11 percent. It has nothing to do with SBP pronouncements. It is as per economists and critics. Exactly in those days, I noticed that some of my clients were obtaining loans at KIBOR+2% which at that time almost amounted to 9 percent or 10 percent in total.

Off course this rate was the nominal interest rate.

I could not understand where has the formula of NOMINAL INTEREST RATE - INFLATION = REAL INTEREST RATE gone at that time.

Becoz if this formula was true

Real interest rate = 9 % - 11% = -2%

It could not be a minus figure.

So, it was irritating.

Regards,

Kamran.

[Schuaeb]

Mark-up percentage now-a-days is normall fourteen plus. And, if we take your stats of inflation, real rate still is three.

However, deposit holder are normally getting return of less than 10%. So, at least they are not getting any gain on their saving.

I guess in an economy like ours its very difficult to calculate the exact inflation rate. However, we all are witnessing some real infaltion for last some time. At least, I, in my 24 yeared life, have never experinced such abrupt rise in price ever before. However, at the same time, the similar trend of increase in incomes should also be consider. So, I guess this inflation has not very drastically reduced purchasing power.

[kamranACA]

Shoaib, now a days rate is almost 7 % for export financings, 11.30% to 11.50% for normal short term financing and almost 12.50 % for long term financing. Export financing rate is lower due to government/SBP policies.

However, I was talking about the circumstances prevailing some two years back.

In Pakistan, some times the real interest rate as per the formula becomes negative. You need to keep an eye on the rates in the longer term.

Further, a very meager real interest rate of e.g. 2 % or 3% is also very strange.

I agree that in Pakistan, estimation of inflation is itself a complex issue.

Regards,

Kamran.

[Schuaeb]

Right Kamran, there was no disagreement at all, infact I was getting things clear for my self.

If we look from depositors point of view, normally the return is 8 or 9%, and max in my knowledge is 11.5% and that too is on some specific long term products. (as msc mentioned too). How would anyone explain this situation that real interest rate for depositors is negative.

As mentioned earlier, interest rate for lending is almost double than what a deposit holder gets on his deposit. Despite clamming enormous economic growth, specifically in financial services sector, and extraordinary profits earned by commercial banks, this situation is terrible or a monetary policy failure.

A sharp decline in interest rates were witnessed during the period of Dr. Ishrat Hussain. Quite some criticism as well as praise for such big change was there. I personally think that it was not a bad decision than (4 or 5 years back) as inflation's situation was not so alarming, PSBR was not very much and every thing was proper for triggering some boost in commercial sectors. Results were there straight away as huge amounts were disbursed by commercial banks to medium and large businesses.

However, afterwards, as an aftermath of 9/11 huge remittances flooded in Pakistan. As interest rates were quite low, so most of the amount was not deposited with banks, instead was invested in speculation business. The unprecedented boom in urban property prices might had been the consequences. Resultantly some uncontrollable inflation was witnessed, which apparently could be called a monetary policy failure.

Despite claiming consistency in policies the government had to take u turn, as regards, interest rates. A rise in interest rates was witnessed. This happened when Dr. Shamshad Akhter became the president. I can say that former president was more investment friendly while the later's policies are more in favour of general public.

Persistent pressure for business circle to reduce interest rates was/or is there on SBP to cut interest rates, but it didn't yield to that pressure. Reason being quite apparent; inflation.

However, I do not how will anybody justify the present difference in interest rate on lending and borrowing.

[CBPian]

You are correct .. we have negative real interest rates for many years which is one of the problems our saving rates are so low.
.. As far as the gap between lending rate and borrowing rate is concerned also called the spread, it is common knowledge that Pakistani banks are charging excessive spreads which was also mentioned by the governor SBP on one of her speaches but she has yet to take any strict action.
You can see the results of these high profits in increase of share prices of all major banks manifolds.