There Is Only So Much That Rajan Can Do About Interest Rates


The next Reserve Bank of India(RBI) monetary policy meeting is scheduled on April 5, 2016. Given this, calls for the RBI governor, Raghuram Rajan, to cut the repo rate, are already being made. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark for the short and medium term interest rates in the economy. So the question is will Rajan cut the repo rate or not?

Most economists quoted in the media are of the belief that Rajan will cut the repo rate by 25 basis points. Of course that is the safest prediction to make at any point of time when the repo rate is on its way down. One basis point is one hundredth of a percentage.

I guess I will leave the kite-flying to others and concentrate on other things, which I think are more important than guessing what Rajan will do. The impression given by those demanding an interest rate cut is that the RBI actually determines all kinds of interest rates in the economy. But that isn’t really true.

As Mervyn King, who was the governor of the Bank of England (the British equivalent of RBI), between 2003 and 2013, writes in his new book The End of Alchemy—Money, Banking and the Future of the Global Economy: “We think of interest rates being determined by the Federal Reserve, the Bank of England, the European Central Bank(ECB) and other national central banks. That is certainly true for short-term interest rates, those applying to loans for a period of a month or less. Over slightly longer horizons, market interest rates are largely influenced by the likely actions of central banks.”

The point being that the ability of central banks to influence interest rates, at most points of time, is limited. At best they can influence short and medium term interest rates. As King writes: “But over longer horizons still, such as a decade or more, interest rates are determined by the balance between spending and saving in the world as a whole, and central banks react to these developments when setting short-term official interest rates.”

The word to mark here is “saving”. In the Indian case the household financial savings have fallen over the years. In 2007-2008, the household financial savings had stood at 11.2% of the gross domestic product (GDP). By 2011-2012, they had fallen to 7.4% of GDP. Since then they have risen marginally. In 2014-2015, the household financial savings stood at 7.7% of GDP.

Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

If interest rates need to fall over the long-term, the household financial savings number needs to go up. And this can only happen if households are encouraged to save by ensuring that a real rate of return is available on their investments. The real rate of return is essentially the rate of return after adjusting for inflation.  A major reason why the household financial savings have fallen over the years is because of the high inflation that prevailed between 2007 and 2013.

It needs to be mentioned here that while the household financial savings have fallen over the years, the private corporate financial savings (basically retained profits of companies) have gone up over the years. In 2007-2008, the private corporate savings had stood at 8.7% of the GDP. In 2014-2015, they stood at 12.7% of the GDP. So, a fall in household financial savings has more than been made up for, by an increase in corporate financial savings.

The trouble is that corporates do not like to lend long term in the financial system. Most of the private corporate savings are invested in short term bonds and mutual funds which in turn invest in short-term bonds. Hence, corporate savings are typically unavailable for long-term borrowers. They need to depend on household financial savings.

Hence, it is important that household financial savings keep increasing in the years to come. Low interest rates are not possible otherwise.

Also, it needs to be mentioned here that the borrowing by state governments has gone up dramatically over the last few years. In 2007-2008, the state governments borrowed Rs 68,529 crore. This number has since then gone up 3.5 times and in 2014-2015 had stood at Rs 2,38,492 crore. A report in the Mint newspaper expects borrowings by state governments to touch Rs 3,00,000 crore in 2015-2016, a jump of more than one-fourth over the borrowing in 2014-2015.

The borrowing by state governments is expected to remain high in the years to come. This is primarily because of the UDAY scheme that the central government has launched to sort out the mess in the power distribution companies all across the country.

Hence, the demand for money which can be invested over the long-term has gone up over the years and is expected to continue to remain high. In this scenario, the supply of money, through household financial savings needs to improve.

If the number does not improve then the interest rate scenario is unlikely to improve irrespective of the RBI pushing the repo rate down. And the number can only improve if savers get a real rate of return on their investment, encouraging people to save more. This has started to happen only over the last two years.

Rajan has often said in the past that he wants to maintain a real interest rate level of 1.5-2%. Real interest is essentially the difference between the rate of interest (in this case the repo rate) and the rate of inflation.

The consumer price inflation on which the RBI bases its monetary policy on, in February 2016, stood at 5.2%. If we to add 1.5% to this, we get 6.7%, which is more or less similar to the prevailing repo rate. The current repo rate stands at 6.75%. Hence, Rajan’s formula is clearly at work.

To conclude, it is worth remembering something that George Gilder wrote in Knowledge and Power: “The fastest growing economies in the world have been heavy savers. Saving powerfully diverts consumption preferences from immediate goods to the array of intermediaries funded by savings. Savings prepare the economy for a long future of growth, compensating for the dwindling harvests of consumption in a world of impetuous spending.”

This is something the rate cut crowd needs to understand.

The column originally appeared on Vivek Kaul’s Diary on March 16, 2016