The finance minister P Chidambaram keeps asking public sector banks to cut interest rates. The assumption here is that because interest rates are high people are not buying things. Once banks start cutting interest rates and people start buying things, businesses will grow and the economy will be back on track again. But that is not the correct way to look at the current economic scenario.
In fact, in a piece that I wrote yesterday I had quoted a paragraph written by investment newsletter writer and hedge fund manager John Mauldin. As Mauldin wrote “The belief is that it is demand that is the issue and that lower rates will stimulate increased demand (consumption), presumably by making loans cheaper for businesses and consumers. More leverage is needed! But current policy apparently fails to grasp that the problem is not the lack of consumption: it is the lack of income.”
Mauldin wrote this with respect to the American economy, but it is equally valid for the Indian economy as well. When politicians ask banks to cut interest rates they assume that people are not buying things because interest rates are high, and hence they will have to pay higher EMIs.
This is partially but not totally true.
This belief does not take into account what Mauldin calls “lack of income”. In India, inflation has been fairly high over the last few years, particularly food inflation. What this has meant is that people have had to spend a higher part of their income on meeting their regular expenditure. This has meant lower savings.
aIn fact, a recent survey carried out by Assocham, found that household savings rates have dropped by a huge 40% in the last three years. “Poor households are unable to maintain the consumption levels at current prices while middle income families find their purchasing power erode fast, thus having far less surplus money,” Assocham Secretary General D S Rawat said on the results of the survey.
In fact, government own data, which is a bit dated, points out towards this trend. The household savings declined from over 12% of GDP in 2007 to under 9% in 2011. It would be safe to say that the savings rate would have fallen further since then.
Getting back to the ASSOCHAM survey, 82% of the respondents felt that their salary increments last year were not in sync with the cost of living, which has gone by nearly 40-45%. Given this, these respondents felt that they had to cut down on their standard of living by at least 25%.
All in all, what this means is that the increase in income over the last few years hasn’t been able to keep pace with inflation. What has also not helped is the fact that interest rates on offer on various kinds of deposits have barely managed to keep pace with the rate of inflation. As the Economic Survey of the government for the year 2012-2013, released in February pointed out “High inflation reduces the return on other financial instruments.”
In this scenario, where savings have gone down and income hasn’t gone up enough to keep pace with high inflation, it is difficult to expect people to buy things. If car sales haven’t grown for while, it is simply because people do not have enough money going around and do not feel confident about the future. It also explains why the consumer durables sector is not doing well.
On the flip side the two wheeler sales have remained robust. This was simply because rural wage growth was robust over the last few years. It was 9.3% in 2012 and 13.4% in 2011, after adjusting for inflation. In August 2013, the rural wage growth moderated to -0.1%. It will be interesting to see where two wheeler sales go from here, given that a large number of two wheelers are bought in rural areas.
Given these reasons, for the consumption story to start all over again, it is important that inflation is brought under control. For that to happen, the high government spending which has been the major reason for inflation needs to be reined in. As economist Arvind Subramanian wrote in a recent column in the Business Standard “A pre-condition, of course, is that fiscal deficits (actual not accounting, current not future), and especially spending, need to be brought under greater control.”
Only once that happens, will the consumption story start looking up again. Till then, we will have to unfortunately hear,Chidambaram ask banks to cut interest rates, over and over again.
The article originally appeared on www.firstpost.com on November 21, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)