There has been considerable hand-wringing over the differential tax treatment accorded to bond investments compared with equity investments in India. Taxation on bonds, bond funds and fixed deposits 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, 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, regardless of taxation.

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 risky 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 area, 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 suddenly were able to borrow at less than a percentage point above German rates after joining the euro area. The excesses that followed led to the eurozone sovereign debt crisis that resulted in Draghi’s bazooka.

Japan, forced to hold rates low after the Plaza Accord, saw stocks and real estate prices zoom 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 an enormous boom in the stock market. When the bubble deflated, the Great Depression resulted.

This author has already pointed out that margin funding of stocks in India has doubled in 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? One can attempt to triangulate an answer based on several theoretical and anecdotal approaches.

First, long-term bond yields (10-year) in a country, in general, are 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 at about 3.5%, resulting in an expected long-term bond yield of 5%, which is almost exactly where the 10-year 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 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%. This almost certainly is too low.

Second, if indeed rates are too low based on this rule of thumb, what consequences might we 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 fast money and exchange-rate depreciation. 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. 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 may help explain why interest rates are drifting 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 interest rates to defend the currency. Yet we chose a different tack, going with the FCNR scheme instead, which, in effect, puts the exchequer on the hook, but under a different classification from that resulting from simply increasing domestic rates.

Taken together, it does appear that Indian interest rates have drifted well below the rule of thumb. The concomitant undesirable effects, including leverage expansion, excessively high valuations of assets, portfolio outflows and currency depreciation, are evident. This drift has been exacerbated by the global spike in yields.

Hikes are coming.