Lower Interest Rates Good for Govt, Banks and Corporates, Not for Average Indian

The new monetary policy committee which met for the first time over the last two days has decided to keep the repo rate unmoved at 4%. Monetary policy committee is a committee which decides on the repo rate of the Reserve Bank of India (RBI). Repo rate is the interest rate at which RBI lends to banks and is expected to set the broad direction for interest rates in the overall economy.

The RBI has been trying to drive down the interest rates in the economy since January 2019. In January 2019, the repo rate was at 6.5%. Since then it has been cut by 250 basis points and is now at 4%. One basis point is one hundredth of a percentage.
This has had some impact in driving down fixed deposit interest rates of banks. Take a look at the following chart.

The Crash


Source: ICICI Securities, October 3, 2020.

From the peak they achieved between March and June 2019, fixed deposit interest rates have fallen by 170 to 220 basis points.
This in an environment where the inflation has been going up. In March 2019, inflation as measured by the consumer price index was at 2.9%. It had jumped slightly to 3.2% by June 2019. In August 2020, the latest data available for inflation as measured by the consumer price index, had jumped to 6.6%. Meanwhile, fixed deposit rates which were around 7-8%, are largely in the range of 4-6% now (of course, there are outliers to this).

Hence, inflation is greater than interest rates on fixed deposits, meaning the purchasing power of the money invested in fixed deposits is actually coming down.

In fact, interest rate on savings bank accounts, which in some cases was as high as 6-7%, has also come down. Take a look at the following chart.

Another crash


Source: ICICI Securities, October 3, 2020.

Savings bank accounts now offer anywhere between 2.5-3%.

The fall in interest rates is not just because of the RBI cutting the repo rate. A bulk of this fall has happened post the covid breakout. Banks haven’t lent money post covid.

Between March 27 and September 25, the outstanding non-food credit of banks has fallen by 1.1% or Rs 1.1 lakh crore to Rs 102 lakh crore. This means that people and firms have been repaying their loans and net-net in the first six months of this financial year, banks haven’t given a single rupee of a fresh loan.

Banks give loans to Food Corporation of India and other state procurement agencies to buy rice and wheat directly from the farmers. Once these loans are subtracted from overall lending by banks, what remains is non-food credit.

During the same period, the deposits of banks have risen by 5.1% or Rs 6.97 lakh crore to Rs 142.6 lakh crore. With people saving more, it clearly shows that the psychology of a recession is in place.

Banks have not been lending while their deposit base has been expanding at a rapid pace. The point being that banks are able to pay an interest on their deposits because they give out loans and charge a higher rate of interest on the loans than they pay on their deposits.

When this mechanism breaks down to some extent, as it has currently, banks need to cut interest rates on their deposits, given that they are not earning much on the newer deposits. This is bound to happen and accordingly, interest rates on fixed deposits have fallen.

While the supply of deposits has gone up, the demand for them in the form of loans, hasn’t. This has led to the price of deposits, which is the interest paid on them, falling.

But there is one more reason why interest rates have fallen. There is excess money floating around in the financial system. The RBI has printed money and pumped it into the financial system by buying bonds from financial institutions.

This excess money has also helped in driving down interest rates. While banks haven’t been able to lend at all in the first six months of the year, the government borrowing has gone through the roof. As the debt manager of the government, the RBI has printed and pumped money into the financial system to drive down the returns on government bond, in the process allowing the government to borrow at lower interest rates. Take a look at the following chart, which plots the returns (or yields) on 10-year bonds of the Indian government.

Going down

Source: Investing.com

The yield on a government bond is the return an investor can earn if he continues to own the bond until maturity. The above chart clearly shows that as the government has borrowed more and more through the year, the interest rate at which it has been able to borrow money has come down, thanks to the RBI and its money printing.

Of course, with banks not lending on the whole, they are happy lending to the government. In fact, in his speech today, the RBI governor Shaktikanta Das said that the central bank planned to print and pump another Rs 1 lakh crore into the financial system in the days to come.

With more money expected to enter the financial system the 10-year government bond yield fell from 6.02% yesterday (October 8) to 5.94% today (October 9), a fall of 8 basis points during the course of the day.

The monetary policy committee also decided to keep the “accommodative stance as long as necessary”, with only one member opposing it. In simple English this means that the RBI will keep driving down interest rates as long as necessary “at least during the current financial year and into the next financial year – to revive growth on a durable basis and mitigate the impact of COVID-19 on the economy.”

The assumption here is that as interest rates fall people will borrow and spend more and corporations will borrow and expand more. This will help the economy grow, jobs will be created and incomes will grow. While, this sounds good in theory, it doesn’t really play out exactly like that, at least not in an Indian context.

Let’s take a look at this pointwise.

1) A bulk of deposits in Indian banks are deposited by individuals. In 2017-18, the latest data for which a breakdown is available, individuals held around 55% of deposits in banks by value. This had stood at 45% in 2009-10 and has been constantly rising. Hence, it is safe to say that in 2020-21, the proportion of bank deposits held by individuals will clearly be more than 55%.

When interest rates on deposits (both savings and fixed deposits) go down individuals get hurt the most. There are senior citizens whose regular expenditure is met through interest on these deposits. When a deposit paying 8% matures and has to be reinvested at 5.5%, it creates a problem. Either the family has to cut down on consumption or start spending some of their capital (the money invested in the fixed deposit).

This also disturbs many people who use fixed deposits as a form of long-term saving. The vagaries of the stock market are not meant for everyone. Also, in the last decade returns from investing in stocks haven’t really been great.

2) When interest rates go down, the families referred to above cut down on consumption and do not increase it, as is expected with lower interest rates. This may not sound right to many people who are just used to economists, analysts, bureaucrats, corporates and fund managers, mouthing, lower interest rates leading to an increase in consumption all the time. But there is a significant section of people whose consumption does get hurt by lower interest rates.

3) It’s not just about bank interest rates going down. Returns on provident fund/pension funds which hold government bonds for long time periods until maturity and post office schemes (despite being higher than banks), also come down in the process.

4) Also, no corporate is going to invest just because interest rates are low right now. Corporates invest and expand when they see a future consumption potential. This is currently missing. Also, banks lending to industry peaked at 22.43% of the GDP in 2012-13. It fell to 14.28% of the GDP in 2019-20. During the period, interest rates have gone up and down, but corporate lending as a proportion of the GDP has continued to fall. So clearly increased borrowing by corporates is not just about interest rates.

But corporates love to constantly talk about high interest rates as a reason not to invest. This is just a way of driving down interest on their current debt.

As former RBI governor Urjit Patel writes in Overdraft:

“Sowing disorder by confusing issues is a tried-and-trusted, distressingly often successful routine by which stakeholders, official and private, plant the seeds of policy/regulation reversal in India.”

One can understand interest rates going down in an environment like the current one, but there is a flip side to it as well, which one doesn’t hear the experts talk about at all. Also, anyone has barely mentioned the excess liquidity in the financial system, which currently stands at Rs 3.9 lakh crore. Why is that? Let’s look at this pointwise.

1)  The equity fund managers love it because with interest rates going down further, many investors will end up investing money in stocks despite very high price to earnings ratio that currently prevails. The price to earnings ratio of the Nifty 50 index currently is at 34.7. This is a kind of level that has never been seen before.

But with post tax real returns from fixed deposits (after adjusting for inflation) in negative territory, many investors continue to bet on stocks, despite the lack of earnings growth.

2) The debt fund managers love it because interest rates and bond prices are negatively related. When interest rates come down, bond yields come down and this leads to bond prices going up. This means that the debt funds managed by these fund managers see capital gains and their overall returns go up. Hence, debt fund managers love lower interest rates.

3) Banks invest a large proportion of the deposits they gather into government bonds. When bond yields fall, bond prices go up. This leads to a higher profit for banks. This in an environment where banks aren’t lending. Hence, bankers love lower interest rates.

4) Corporates love lower interest rates at all points of time, irrespective of whether they want to borrow or not. I don’t think this needs to be explained.

5) The government loves low interest rates because it can borrow at lower rates. Second, with the stock market going up, it can sell a positive narrative. If the economy is doing so badly, why is the stock market doing well?

6) This leaves economists. Economists love lower interest rates because the textbooks they read, said so.

The question is do lower interest rates or interest rates make a difference when it comes to borrowing by an average Indian? Let’s take a look at non-housing retail borrowing from banks over the years. In 2007-08 it stood at 5.34% of the gross domestic product (GDP). In 2019-2020, it stood at an all-time high of 5.97% of GDP.

In a period of 12 years, non-housing retail borrowing from banks, has barely moved. What it tells us to some extent is that the idea of taking on a loan to buy something (other than a house), is still alien to many Indians.

So, the idea that interest rates falling leading to increased retail borrowing is a little shaky in the Indian context.

To conclude, today the RBI governor Shaktikanta Das gave a speech which was more than 4,000 words long. In this speech, the phrase fixed deposit interest rate did not appear even once.

A whole generation of savers is getting screwed (for the lack of a better word) and the RBI Governor doesn’t even bother mentioning it in his speech. The RBI seems to be constantly worried about the interest rate at which the government borrows.

A central bank which only bats for the government, corporates and bond market investors, is always and anywhere a bad idea.

Shaktikanta Das’ RBI is at the top of this bad idea.

 

Mr Subramanian, Lower Interest Rates Do Not Always Lead to More Bank Loans

Arvind_Subrahmaniyam

“Lower interest rates lead to higher lending,” is something that most economists firmly believe in. The beliefs of Arvind Subramanian, the chief economic adviser to the ministry of finance, are not an exception to this rule.

Hence, not surprisingly in a lecture a few days back he came out all guns blazing against the Reserve Bank of India(RBI) for not cutting the repo rate. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loan. We say sort of a benchmark here because there are other factors which go into deciding what rate of interest that banks charge on their loans.

Subramanian wants the RBI to cut the repo rate further from its current level of 6.25 per cent. As he said: “Inflation pressures are easing considerably… the inflation outlook is benign because of a number of economic developments… Against this background, most reasonable economists would say that the economy needs all the macroeconomic policy support it can get: instead, both fiscal policy and monetary policy remain tight.

The point here being that current inflation is under control and from the looks of it, future inflation should also be under control. And given this, the RBI must cut its repo rate. The RBI last cut the repo rate in October 2016. And as and when it cuts the rate further, the hope is that the banks will cut their lending rates. Only then will people and industries both borrow and spend more. This will give a flip to the economy. QED.
Subramanian’s point is well taken. Nevertheless, does it make sense? We will deviate a little here before we arrive at the answer.

The RBI Monetary Policy Report released in early April 2017 points out that the decline in the one-year marginal cost of funds based lending rates (MCLRs) of banks between April and October 2016 was just 15 basis points. This when the repo rate was cut by 50 basis points. Hence, even though the RBI cut its repo rate by 50 basis points, the banks cut their lending rates by just 15 basis points, a little under a one-third. One basis point is one hundredth of a percentage.

Post demonetisation “27 public sector banks have reduced their one-year median MCLR in the range of 50 to 105 bps, and 19 private sector banks have done so in the range of 25 to 148 bps.” This when the repo rate has not been cut at all. On an average the one year MCLRs of banks fell by 70 basis points to 8.6 per cent.

What has happened here? A cut in the repo rate barely makes any difference to the cost at which banks have already borrowed money to fund their loans. But demonetisation did. The share of the “low cost current account and savings account (CASA) deposits in aggregate deposits with the SCBs went up to 39.2 per cent (as on March 17, 2017) – an increase of 4.0 percentage points relative to the predemonetisation period”. This is because people deposited the demonetised notes into the banks and this money was credited against their accounts.

This basically meant that banks suddenly had access to cheaper deposits because of demonetisation. And this in turn led them to cut interest rates on their loans, despite no cut in the repo rate. The RBI’s repo rate continued to be at 6.25 per cent during the period.

A cut in lending rates is only one part of the equation. The bigger question has it led to higher borrowings? Are people and businesses borrowing more because lending rates are now lower than they were in the past? And this is where things become interesting.
The total deposits of banks between October 28, 2016 (before demonetisation) and December 30, 2016 (the last date to deposit demonetised currency into banks) went up by 6.41 per cent to Rs 10,568,17 crore. This was a huge jump during a period of two months. This sudden increase in liquidity led to banks cutting their deposit rates and then their lending rates.

Interestingly, the total deposits of banks have continued to remain stable and as of April 30, 2017, were at Rs 10,509,337 crore. This is a minor fall of 0.6 per cent since December 2016.

Between end October 2016 and end April 2017, only around 36 per cent of the incremental deposits raised by banks were loaned out. (We are looking at non-food credit here. The total bank loans that remain after we adjust for the loans that have been given to the Food Corporation of India and other state procurement agencies for the procurement of rice and wheat produced by farmers).

This means for every new deposit worth Rs 100, the bank loaned out just Rs 36, despite a cut in interest rates.

If we were to look the same ratio between end October 2015 and end April 2016, it projects a totally different picture. 116 per cent of the incremental deposits during the period were lent out. This means for every new deposit worth Rs 100, the bank loaned out Rs 116.  This means that deposits raised before the start of this period were also lent out.

Hence, a greater amount of lending happened at higher interest rates between October 2015 and April 2016. And this goes totally against Subramanian’s idea of the RBI needing to cut the repo rate. It also goes against the idea of banks lending more at lower interest rates.

Given this, low interest rates are only a part of the story. If that is not leading to higher lending, it doesn’t help in anyway. Lending isn’t happening due to various reasons, which we keep discussing. Demonetisation has only added to this issue.

Also, a fall in interest rates hurts those who depend on a regular income from fixed deposits to meet their expenditure. It also hurts those who are saving for their long-term goals. In both the cases, expenditure has to be cut down. In one case because enough regular income is not being generated and in another case in order to be able to save more to reach the investment goal. And this cut in spending hurts the overall economy. Interest rates are also about the saver and depositor.

We are yet to see a professional economist talk from this angle. To them it is always a case of garbage in garbage out i.e. lower interest rates lead to increased lending. This is simply because most professional economists these days get trained in the United States where the system is totally different and lower interest rates do lead to a higher borrowing by businesses and people.

But that doesn’t necessarily work in India. It is a totally different proposition here.

The column originally appeared in Equitymaster on May 15, 2017.

Cut Interest Rates by 2 per cent: The New Economics of Nirmala Sitharaman

Nirmala Sitharaman Spokesperson 11, Ashoka Road, New Delhi - 110001.

BA Kiya Hai, MA Kiya,
Lagta Hai Wo Bhi Aiwen Kiya.
– Gulzar in Mere Apne

The commerce and industry minister Nirmala Sitharaman wants the Reserve Bank of India(RBI) to cut the repo rate by 200 basis points.

Yes, you read that right!

200 basis points!

The repo rate is the rate at which banks borrow from the RBI on an overnight basis. One basis point is one hundredth of a percentage. The repo rate currently stands at 6.5 per cent.

I still hold that the cost of credit in India is high. Undoubtedly, particularly MSMEs which create a lot of jobs contribute to exports… are all hard pressed for money and for them, approaching a bank is no solution because of the prevailing rate of interest. I have no hesitation to say, yes 200 bps, I would strongly recommend,” Sitharam told the press yesterday in New Delhi.

What Sitharaman was basically saying is that India’s micro and small and medium enterprises(MSMEs) are not approaching banks for loans because interest rates are too high. Given this, the RBI should cut the repo rate by 200 basis points and in the process usher in lower interest rates for MSMEs.

This, according to Sitharaman, was important because MSMEs create a lot of jobs and contribute to exports, and hence, should be able to borrow at a lower interest rates, than they currently are. As per the National Manufacturing Policy of 2011, the small and medium enterprises contribute 45 per cent of the manufacturing output and 40 per cent of total exports.

Hence, Sitharaman was batting for the MSMEs. But is it as easy as that?

That politicians don’t understand economics, or at least pretend not to understand it, is a given. But Sitharaman is a post graduate in economics from the Jawaharlal Nehru University in Delhi. (You can check it out here). For her, to make such an illogical remark, is rather surprising.

Not that the RBI is going to oblige her, but for a moment let’s assume that it does, and cuts the repo rate by 200 basis points, in the next monetary policy statement, which is scheduled for October 4, 2016, or over the next few statements.

What is going to happen next? Will banks cut their lending rates by 200 basis points? Only, when the banks cut their lending rates by 200 basis points, is the MSME sector going to benefit.

Banks only borrow a small portion of money from the RBI on an overnight basis and pay the repo rate as interest. A major portion of the money that they lend is borrowed in the form of fixed deposits. Hence, lending rates cannot fall by 200 basis points, unless fixed deposit interest rates fall by at least 200 basis points. (I use the word at least because banks tend to cut deposit rates faster than lending rates).

Wil the banks cut deposit rates by 200 basis points? Let’s assume that they do. If the deposit rates are cut by such a huge amount at one go, people will not save money in fixed deposits. Money will move into post office savings schemes, which offer a significantly higher rate of interest in comparison to fixed deposits (which they do even now, but with a cut the difference will be substantial).

Over a longer period of time, money will also move into real estate and gold, as people start looking for a better rate of return, higher than the prevailing inflation. This will lead to the financial savings of the nation as a whole falling. And banks in order to ensure that deposits keep coming in, will have to reverse the 200 basis points cut and start raising interest rates.

This is precisely how things played out between 2009 and 2013, when household financial savings fell from 12 per cent of the GDP to a little over 7 per cent of the GDP. Meanwhile, the interest rates went up, in order to attract financial savings.

This is Economics 101, which a post graduate in economics from a premier university in the country, should be able to understand.

Another important issue that our politicians seem to forget, over and over again, is the importance of fixed deposits, as a mode of saving, in an average Indian’s life. In 2013-2014, the latest year for which data is available, 69.23 per cent of total household financial savings, were in deposits.

Of this nearly 62.02 per cent was with scheduled commercial banks and 4.19 per cent with cooperative banks and societies. Nearly 2.61 per cent was invested in deposits of non-banking companies.

What does this tell us? It tells us that for the average Indian, the fixed deposit is an important form of saving. For the retirees it is an important form of regular income. Now what happens if fixed deposit interest rates are cut by 200 basis points? The regular income from the fresh money that retirees invest, will come down dramatically. Also, when their old fixed deposits mature, they will have to be invested at a significantly lower rate of interest.

This means that they will have to limit their consumption in order to ensure that they meet their needs from the lower monthly income that their fixed deposits are generating.

What about those who use fixed deposits as a form of saving? (I know that fixed deposits are a terribly inefficient way of saving, but that is really not the point here). Those who are using fixed deposits to save money, for their retirement, for the education and wedding of their children, will now have to save more money, in order to ensure that they are able to create the corpus that they are aiming at. This will also mean lower consumption.

Ultimately lower consumption will impact MSMEs as well, because there won’t be enough buyers for what they produce, as people consume less.

Those individuals who are not in a position to save the extra amount in order to make up for lower interest rates, will end up with a lower corpus in the years to come.

The point being that MSMEs do not operate in isolation. And the level of interest rates impacts the entire economy and not just the MSMEs, as Sitharaman would like us to believe.

Further, even if fixed deposit rates fall by 200 basis points, banks may still not be able to offer low interest rates to MSMEs, simply because they need to charge a credit risk premium i.e. factor in the riskiness of the loan that they are maing.

In case of the State Bank of India, the gross non-performing assets of SMEs stands at 7.82 per cent, as on March 31, 2016. This means that for every Rs 100 that the bank has lent to an SME, close to Rs 8 has been defaulted on. This risk of default needs to incorporated in the interest rate that is being charged.

And finally, the interest rates on fixed deposits of greater than one year are currently in the region of 7 to 7.5 per cent. This is when the rate of inflation has already crossed 6 per cent. In July 2016, the rate of inflation as measured by the consumer price index was at 6.07 per cent.

If fixed deposit rates are cut by 200 basis points, the interest rates will fall to around 5 to 5.5 per cent. This when the rate of inflation is greater than 6 per cent. This would mean that the real rate of interest (the difference between the nominal rate and the rate of inflation) would be in a negative territory. This is precisely how things had played out between 2009 and 2013 and look at the mess it ended up creating for the Indian economy.

Given these reasons, it is best to say that Sitharaman’s prescription would be disastrous for the Indian economy.

The column originally appeared in Vivek Kaul’s Diary on August 25, 2016

The Biggest Challenge for the New RBI Governor Urjit Patel is…

o-URJIT-PATEL-facebook-1

 

On Saturday, August 20, 2016, the Narendra Modi government appointed Urjit Patel, as the 24th governor of the Reserve Bank of India(RBI). He will take over fromRaghuram Rajan, on September 4, 2016.

Since Patel’s appointment two days back, a small cottage industry has emerged around trying to figure out what his thinking on various issues is. The trouble is that Patel has barely given any speeches, or interviews, for that matter, since he became the deputy governor of the RBI, in January 2013.

A check on the speeches page of the RBI tells me that he has given only one speech (you can read it here) and one interview (you can read it here) in the more than three and a half years, he has been the deputy governor of the RBI.

You can’t gauge much about his thinking from the speech which is two and a half pages long. As far as the interview goes, Patel has answered all of three questions. Some of his thinking can be gauged from the Report of the Expert Committee to Revise and Strengthen the Monetary Policy Framework¸ of which he has the Chairman. The report was published in January 2014 and ultimately became the basis for the formation of the monetary policy committee, which will soon become a reality.

There are also a few research papers that he has authored over the years.

Given this, Patel’s thinking on various issues will become clearer as we go along and as he interacts more with the media in the days to come. While he may have managed to avoid the media in his role as the deputy governor that surely won’t be possible once he takes over as the RBI governor. He may not make as many speeches as his predecessor did (which is something that the Modi government probably already likes about him), but there is no way he can avoid interacting with the press, after every monetary policy statement, and giving interviews now and then.

Given this, the policy continuity argument being made across the media about Patel being appointed the RBI governor, is rather flaky. There isn’t enough evidence going around to say the same. The only thing that can perhaps be said from what Patel has written over the years is that his views on inflation seem to be in line with Rajan’s thinking. Also, some of the stuff that is being cited was written many years back. And people do change views over the years. There is no way of knowing if Patel has.

The Challenges for the new RBI governor

While, his thinking on various issues may not be very clear, it doesn’t take rocket science to figure out what his bigger challenges are. Take a look at the following chart. It maps the inflation as measured by the consumer price index since August 2014.

Inflation as measured by the consumer price index

The chart tells us very clearly that the inflation as measured by the consumer price index is at its highest level since August 2014. In August 2014, the inflation was at 7.03 per cent. In July 2016, it came in at 6.07 per cent.

Why has the rate of inflation as measured by the consumer price index, spiked up? The answer lies in the following chart which shows the rate of food inflation since August 2014.

 

Food Inflation

 

Like the inflation as measured by the consumer price index, the rate of food inflation is also at its highest level since August 2014. In August 2014, the food inflation was at 8.93 per cent. In July 2014, the food inflation was at 8.35 per cent. Food products make for a greater chunk of the consumer price index.

What this tells us is that the inflation as measured by the consumer price index spikes up when the food inflation spikes up. And that is the first order effect of high food inflation. This becomes clear from the following chart.

Inflation

But what can the RBI do about food inflation?

There is not much that the RBI can do about food inflation. And this is often offered as a reason, especially by the corporate chieftains and those close to the government (not specifically the Modi government but any government), for the RBI to cut the repo rate. The repo rate is the rate of interest that the RBI charges commercial banks when they borrow overnight from it. It communicates the policy stance of the RBI and tells the financial system at large, which way the central bank expects interest rates to go in the days to come.

The trouble is that things are not as simplistic as the corporate chieftains make them out to be. While, the RBI has no control over food inflation (and not that the government does either), it can control the second-order effects of food inflation.

As D Subbarao, former governor of the RBI, writes in his new book Who Moved My Interest Rate?-Leading the Reserve Bank of India Through Five Turbulent Years: “What about the criticism that monetary policy is an ineffective tool against supply shocks? This is an ageless and timeless issue. I was not the first governor to have had to respond to this, and I know I won’t be the last. My response should come as no surprise. In a $1500 per capita economy-where food is a large fraction of the expenditure basket-food inflation quickly spills into wage inflation and therefore into core inflation…When food has such a dominant share in the expenditure basket, sustained food inflation is bound to ignite inflationary expectations.”

Given this, the entire logic of the RBI cutting the repo rate because it cannot manage food inflation is basicallybunkum. Food inflation inevitably translates into overall inflation and that is something that the RBI has some control over, through the repo rate. If this is not addressed, second order effects of food inflation can lead to an even higher inflation as measured by the consumer price index. And this will hurt a large section of the population.

As Subbarao writes: “The Reserve Bank of India cannot afford to forget that there is a much larger group that prioritizes lower inflation over a faster growth. This is the large majority of public comprising of several millions of low-and-middle-income households who are hurt by rising prices and want the Reserve Bank to maintain stable prices. Inflation, we must note, is a regressive tax; the poorer you are, the more you are hurt by rising prices.”

But one cannot expect corporate chieftains who have taken on a huge amount of debt over the years, in order to further their ambitions, to understand this rather basic point. Given this, this hasn’t stopped them from demanding a repo rate cut from the new RBI governor. (You can read more about it here). The government has also made it clear over and over again that it wants the RBI to cut the repo rate. Given that, it is the biggest borrower, this is not surprising. Since January 2015, the RBI has cut the repo rate by 150 basis points to 6.5 per cent. One basis point is one hundredth of a percentage.

As Subbarao writes: “The narrative of our growth-inflation debate is also shaped by what I call the ‘decibel capacity’. The trade and the industry sector, typically a borrower of money, prioritizes growth over inflation, and lobbies for a softer interest-rate regime.”

The people who invest in deposits unlike the corporate chieftains are not in a position to lobby. But it is important that the RBI does not forget about them.

Hence, it is important that people are offered a positive real rate of interest on their fixed deposits. The real rate of interest is essentially the difference between the nominal rate of interest offered on fixed deposits and the prevailing rate of inflation. A positive real rate of interest is important in order to encourage people to save and build the domestic savings of India, which have been falling over the last few years.

This was one of the bigger mistakes made during the second-term of the Manmohan Singh government.

As outgoing governor Raghuram Rajan told NDTV in an interview sometime back “When inflation was 9 per cent they [i.e. depositors] were getting 9 per cent. This meant earning nothing in real terms and losing everything in inflation.”

This wasn’t the case for many years. As Rajan explained in a June 2016 speech: “In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.”

Inflation up, savings down

Take a look at the following chart clearly shows that between 2008 and 2013, the real rate of return on deposits was negative. In fact, it was close to 4 per cent in the negative territory in 2010.

 

Inflation as measured by the consumer price index

 

High inflation essentially ensured that India’s gross domestic savings have been falling over the last decade. Between 2007-2008 and 2013-2014, the rate of inflation as measured by the consumer price index, averaged at around 9.5 per cent per year. In 2007-2008, the gross domestic savings peaked at 36.8 per cent of the GDP. Since then they have been falling and in 2013-2014, the gross domestic savings were at 30.5 per cent of the GDP, having improved from a low of 30.1 per cent of GDP in 2012-2013.

This fall in gross domestic savings has come about because of a dramatic fall in household financial savings. 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.

Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6 per cent of the GDP. In 2009-2010, it rose to 12 per cent of GDP. By 2011-2012, it had fallen to 7 per cent of the GDP. The household financial savings in 2014-2015, stood at 7.5 per cent of GDP. Chances of this figure having improved in 2015-2016 are pretty good given that a real rate of return on deposits is on offer for savers, after many years.

If a programme like Make in India has to take off, India’s household financial savings in particular and overall gross domestic savings in general, need to be on solid ground. And that is only going to happen if people are encouraged to save by ensuring that they make a real rate of return on their deposits. In fact, if India needs to grow at 10 per cent per year, an estimate made in Vijay Joshi’s book India’s Long Road suggests that the savings rate will have to be around 41 per cent of the GDP.

As Rakesh Mohan and Munish Kapoor of the International Monetary Fund write in a research paper titledPressing the Indian Growth Accelerator: Policy Imperatives: “In the near future, we expect financial savings to be restored to the earlier 10 per cent level, as inflation subsides, monetary conditions stabilize and households begin to obtain positive real interest rates on their deposits and other financial savings. Financial savings are then projected to increase gradually to around 13 per cent by 2027-32.”

And how is this going to happen? As Mohan and Kapoor point out: “A sustained reduction in inflation that leads to the maintenance of low nominal interest rates, but positive real interest rates, will help in restoring corporate profitability, while encouraging household savings towards financial instruments.”

The point is that a scenario where a positive real rate of return is available to depositors is very important. But is that how things will continue to be? Take a look at the following chart, which plots the repo rate and the consumer price inflation.

Inflation as measured by the consumer price index

As can be seen from the graph, the difference between the repo rate (the orange line) and overall inflation (i.e. inflation as measured by the consumer price index) has narrowed considerably and is at its lowest level in the last two years. This effectively means that the real rate of return on fixed deposits offered by banks has been falling as the rate of inflation has been going up. (Ideally, I should have taken the average rate of return on fixed deposits instead of the repo rate, but that sort of data is not so easily available. Hence, I have taken the repo rate as a proxy).

This is not a good sign on several counts. In a country like India where deposits are a major way through which people save, high inflation leading to lower real rates of interest which effectively means that they are not saving as much as they should. This is something that most people do not seem to understand.

The economist Michael Pettis makes a very interesting point about the relationship between interest rate and consumption in case of China. As he writes in The Great Rebalancing: “Most Chinese savings, at least until recently, have been in the form of bank deposits…Chinese households, in other words, should feel richer when the deposit rate rises and poorer when it declines, in which case rising rates should be associated with rising, not declining, consumption.”

Now replace China with India in the above paragraph and the logic remains exactly the same. Given that a large portion of the Indian household financial savings are invested in bank deposits, any fall in interest rates (as the corporate chieftains regularly demand) should make people feel poorer and in the process negatively impact consumption, at least from the point of savers.

Given this, the biggest challenge for Urjit Patel will be to not taken in by all these demands for lower interest rates and ensure that the deposit holders get a real rate of interest on their fixed deposits.

Further, it is unlikely that he will cut the repo rate given that as the monetary policy committee comes in place, the RBI needs to maintain a rate of inflation between 2 to 6 per cent. In July 2016, the rate of inflation was over 6 per cent.

The column originally appeared in Vivek Kaul’s Diary on August 22, 2016

 

Bhaktonomics 101: All You Wanted to Know but Were Afraid to Ask

ARTS RAJAN

There is economics and then there is Bhaktonomics–or so called economics which is used regularly these days, to justify the actions of the Narendra Modi government.

This new faction of economics has never been explored before—at least not until today. In this column I will look at Bhaktonomics that is being used to justify why Raghuram Rajan should not have been offered a second term, as the governor of the Reserve Bank of India.

Here are a few arguments being made:

a) Rajan wasn’t cutting interest rates fast enough: This is an old argument that keeps getting made whenever a central bank does not cut interest rates as the government of the day would like it to. So the followers of Bhaktonomics say that Rajan should not have got a second term because he was not cutting interest rates fast enough.

The irony is that Rajan did cut the repo rate. The repo rate has been cut by 150 basis points since January 2015. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

But let’s leave that aside for a moment. Hence, the argument is Rajan wasn’t cutting interest rates fast enough. And because he wasn’t cutting interest rates fast enough, the bank lending had been growing at a slow rate. Since bank lending has been growing at a slow rate, individuals haven’t been borrowing to spend and companies to expand. Hence, economic growth hasn’t been robust enough. Given this, Rajan had to go.

But didn’t India grow at 7.6% in 2015-2016? Isn’t India the fastest growing major economy in the world? I personally don’t believe that India is growing at 7.6%. There are many other sceptics as well. But try telling that to the practitioners of Bhaktonomics and see how they react.

So, if India is indeed growing at 7.6%, and is the fastest growing major economy in the world, then Rajan has cut interest rates fast enough. And if he has cut interest rates fast enough, why is he being fired? Okay, okay. He has not been fired. He has chosen to go on his own.

If India is growing at 7.6%, then Rajan has cut interest rates fast enough. Or to put it as the conventional economists do, he hasn’t been behind the curve. On the flip side, if he hasn’t cut interest rates fast enough, then India isn’t growing at 7.6%. The broader point being that you can’t have it both ways like the Bhaktonomists are currently.

There are other points on the interest rate front that need to be made here. Rajan ensured that the real rate of interest on deposits was in positive territory, after a long time. This basically means that the difference between the nominal rate of interest on deposits minus the prevailing rate of inflation, is in positive territory.

This worked well for savers who had seen inflation eat away their hard earning during the Manmohan Singh years. It has also helped household financial savings grow, as less money went into gold and real estate, in comparison to the past. It is ultimately these financial savings which will finance the Make in India programme. So Rajan essentially was batting for the government and not against it, as Bhaktonomists have been pointing out.

But a real rate of interest for depositors means that the government had to bear a high rate of interest on its borrowings, something it is clearly not comfortable doing. This is after many years of paying a lower rate of interest on its borrowings than the prevailing rate of inflation.

Take a look at the following chart:

 

The green line is the rate of inflation. And the red line is the interest that the government pays on what it borrows. Between 2007 and 20013, the government paid a lower rate of interest than the prevailing rate of inflation.

The real rate of interest available to the depositors these days, does not allow the government to do that. Hence, as the biggest borrower going around, it wants lower interest rates. QED.

The saver be dammed. Bhaktonomics has no place for the savers. They are only bothered about the borrowers, which includes the government and the crony capitalists.

b) Individuals are not important/Nobody is indispensable: This is another point that is being vociferously made to justify the exit of Rajan. This is absolute rubbish. If that was the case then Manmohan Singh, would have still been prime minister.

Individuals make institutions and governments. They make institutions and they destroy them as well. Hence, individuals are important. What India lacks are institutions. One man cannot take this country out of the rut that it is in. Good institutions can. And institutions are ultimately built as well as nurtured by individuals. So saying that individuals are not important is not even an argument.

Also, India’s government these days gets as much attention as it does, globally, primarily because Narendra Modi heads it. Modi is an individual. His being the head of the Indian government gives it more credibility than the last one and given that he matters. And like he matters, so does Rajan, when it comes to the RBI.

Further, you don’t hound out an employee who is doing well, especially when you have a serious talent crunch anyway, when the best brains do not want to work for the government (and I mean any Indian government here not just this government) and stay far away from it. If something is working why try and destroy, in order to fix it again? Beats me. Perhaps, Bhaktonomics has an explanation for this as well.

Also, the next RBI governor, whoever he or she is, will take time to settle into the job. And precious time will be lost. This is when inflation has started to go up again. So have oil prices. The cleaning up of bad loans of banks has reached a very important stage. Continuity would have been good here.

In fact, The Indian Express reports that earlier this year the government scrapped the search for a new chief of the Securities and Exchange Board of India(Sebi) and extended the term of UK Sinha on the pretext that ““continuity may be desirable” at times of “excessive volatility — mainly due to external factors””.

If this was true for Sebi earlier this year, it is more than true for the RBI at this point of time. So, why the double standards? Also, UK Sinha, the Sebi chief, like Rajan, is a UPA appointee.

c) It’s the government’s prerogative to decide who works for it: This is the third argument being made justifying Rajan’s exit and is by far the most sensible of the lot. Also, it is better than saying nobody is indispensable.

But is this the way you hound out an RBI governor, when RBI remains one of the few government institutions which hasn’t degraded over the years? You don’t let an unelected member of Parliament run a malicious campaign against the RBI governor and then come out and say this is not the party’s stated position on the issue.

If you didn’t want him, the same could have been communicated to him, in a good way. Tata, bye bye.

The way Rajan’s exit has been handled, it is clear that the message that the government wants to send out is, that if you want to work for us, then you need to be a cheerleader (or  team player as the euphemism goes), and if you have an opinion your own, then it’s better to keep your mouth shut.

As Chandan Mitra of the BJP put it in a column on NDTV.com: “He also demonstrated a less-than-patriotic enthusiasm to play cheerleader, expected to tom-tom his government’s achievements.”

The column originally appeared in Vivek Kaul’s Diary on June 21, 2016