There has been considerable hand-wringing over the differential tax treatment accorded to bond investments compared with equity investments in India. Unequal taxation on bonds, bond funds and fixed deposits compared with equities has essentially made these unviable for all but the most risk-averse investors.

While this asymmetry in taxation is undoubtedly a factor in driving the marginal investor away from fixed income and into equities, another question worth asking is whether the level of interest rates is appropriate at all. An investment that yields less than what is fair will eventually fall out of favour, with taxation playing a secondary role.

An interest rate that is lower than warranted has other undesirable effects. The government bond yield, in effect, acts as the minimum hurdle rate against which rates of return expected on other assets need to be benchmarked. Keep this too low and returns expected from risky assets also fall. This manifests itself in asset price inflation, which may lead to bubbles.

Greece after it joined the euro bloc, Japan after the Plaza Accord and the US just before the Great Depression of 1929 come to mind as case studies.

Borrowers in Greece who, prior to the country’s joining the euro area, were used to paying interest rates as high as 10 percentage points above German rates were suddenly able to borrow at only a percentage point above German rates after joining the euro area. The excesses that followed led to the eurozone sovereign debt crisis.

Japan, forced to hold rates low after the Plaza Accord, saw stocks and real estate prices surge in the years that followed, which ultimately resulted in the lost decades in Japan.

The US chose to cut rates to help the UK stay on the gold standard in 1927, which led to a boom in the stock market. When the bubble deflated, the Great Depression resulted.

This author has already highlighted the doubling of margin funding over the last three years, resulting in sky-high valuations for non-large-cap stocks that have become the target of the speculative excesses of retail traders moving on from their losses in options trading. This jump in margin funding may have been helped along by interest rates that may be too low.

How can one judge whether interest rates in India are appropriate? This is always a difficult exercise, but one can attempt to triangulate an answer based on several theoretical and anecdotal approaches.

First, long-term bond yields (10-year) in a country are, in equilibrium, anchored to its nominal GDP growth rate, which can be viewed as real GDP growth plus inflation. By way of a few illustrative examples, in the US, real GDP is running at around 1.5% and inflation is running at about 3.5%, resulting in an expected long-term bond yield of 5%, which is almost exactly where the 10-year US Treasury yield sits.

In the euro area, real GDP growth of 0.5% plus inflation of about 3.2% yields an expected 10-year bond yield of approximately 3.7%, which is almost exactly where the average of the German and French 10-year yields is. This rule of thumb works well for developed economies where capital flows are unrestricted, while bond yields in economies without free capital flows, mostly emerging markets, generally tend to be higher than implied by this rule of thumb.

Judged by this rule of thumb, with a real GDP growth rate of, say, 7% and inflation of about 4%, a baseline for India’s 10-year bond yield is 11%. It sits presently at 7%. If one does not debate the accuracy of these GDP and inflation numbers, this is almost certainly much too low.

Second, if indeed rates are too low based on this rule of thumb, what consequences might we expect to see? Theory says that if investors in an economy do not receive an adequate real rate of return — nominal rate minus inflation — they will seek to deploy their money elsewhere, leading to an exit of portfolio investments and exchange-rate depreciation. This is not restricted only to foreign bond investments, as overall rates of return across all investments become too low, as discussed above. This is precisely what we have seen in India over the last few years.

Third, look at incentives. Financing deficits sustainably requires low interest rates, in addition to captive-demand-generating regulations like SLR, to keep debt-servicing payments low. In the US, where interest rates have spiked in this decade, as has the deficit, debt-service payments are now about 50% of new borrowing. This has led to direct intervention by the US Treasury to hold yields down. In India, interest expense as a proportion of new borrowing is even higher, at close to 80%. Absent a drastic improvement in tax collection, India just cannot afford higher interest rates at this level of spending, which suggests why interest rates have been allowed to drift well below the rule-of-thumb measure.

Fourth, assess the policy choices made by stewards of the economy in the face of reserve depletion this year. A logical choice is to raise domestic interest rates to defend the currency. Yet we chose a different tack, going with the FCNR scheme instead, which, in effect, raises the interest rate available only to foreign-currency depositors and puts the exchequer on the hook regardless, but under a different classification from that resulting from simply increasing domestic rates. It suggests, once again, that raising interest rates is the least desirable policy choice.

Taken together, it does appear that Indian interest rates have drifted well below the rule-of-thumb measure. The concomitant undesirable effects, including leverage expansion, excessively high valuations of assets, portfolio outflows and currency depreciation, are evident. The extent of this drift has been exacerbated by the recent global spike in yields, which may ultimately force the RBI’s hand, forcing it to choose between hikes and further currency depreciation.