Not in People's Interest

Economic laws and principles are not bound to be people-friendly, but on many occasions the right kind of economics tends to help masses. A decline in the interest rate on fixed deposits in banks, justified in the face of a declining inflation rate and perennially desired by the government as necessary to promote investment, is clearly anti-people, even if supported by apparently good economic logic. Since the country’s central bank is not in the business of assessing people’s welfare and is guided by sound economic logic, the government should have taken initiative to provide a broader picture of reality and the associated good economics.

Unfortunately for the people, whose living conditions are entirely dependent on small amounts of saving and are frightened to invest in the stock market or any other avenues of investment because of their incapacity to undertake risk, the cutback in interest rates spells disaster. But given the close connections between the media and the lobbies that are continuously after a reduction in interest rates, the affected voices are not allowed to be heard, and the government fails to provide them the dignity they deserve. In this brief note, I am going to talk about only economics that is being ignored or not highlighted because of different kinds of vested interests.

We know from the interest rate parity condition that the differences in the interest rates between countries must be explained by expected depreciation in the exchange rate, translated as inflation rate with some assumptions on purchasing power parity conditions and a risk premium beyond fluctuation in prices. Hence, cross-country differences must be based on a good measure of risk premium. I am sure economists at the Reserve Bank of India (RBI) have done the necessary calculations and have reason to tag the interest rate solely on the inflation rate. I do not know whether economists at the RBI have calculated the long-run real rate of interest rates for the world and for India. To a common man, the movement in the cost-of-living index is the number to focus on, and its rate of increase has to be subtracted from the fixed deposit rates to check the real interest rate we receive. There have been occasions in the past when real rates of interest declined and lenders have lost out. When real rates rise, lenders must be allowed some time to recover that loss. Do we have a mechanism for that? We do not.

Passing the Burden

Banks are happy if they have to pay less to the depositors, particularly when the level of non-performing assets (NPAs) has skyrocketed. Such unrealised interest earnings is putting pressure on them precisely because many big shots have not paid back their loans, which includes those who are gung-ho regarding a cut in the borrowing rate. Are we not passing the burden of adjustment from crooks to small lenders by reducting the deposit rate? We hardly see any discussion on such a general equilibrium link.

Many countries in Europe and even the United States, though to a lesser extent, have strong social security provisions that help retired people and guarantee basic social protection for everyone. We do not have such a system. Hence the lending rate should have a premium over risk and inflation-adjusted global rates to help small and medium lenders. This point is missed by erudite policymakers. The policy failure of the government must not be camouflaged by sound economics.

In an earlier article in this weekly (“The Interest Rate Affair,” EPW, 4 April 2015), I have tried to draw attention to the conventional wisdom that a decline in the interest rate hardly stimulates long-term investment in India by drawing on basic textbook result and research by RBI economists. As a matter of fact such a relationship is a myth anywhere in the world, as long-term expectations of aggregate demand as well as public investment in infrastructure are far more critical factors in promoting investment. Has the government published a white paper worthy of publication in a top international journal on how the interest rate affects investment in the country, and have established a solid link between a decline in the interest rate and an increase in the rate of investment? We are yet to see one, while the poor lender has to be made the scapegoat of bad economics.

The decline in the borrowing rate will stimulate housing and car markets by creating demand for them, but would definitely increase profits even if there is no change in demand. Therefore, a sound policy will be to impose an extra profit tax on pre-existing sales, and to redistribute it as an interest subsidy to small lenders. If 100 cars were sold before and now it becomes 120, why should the firm get the benefit of a lower interest cost on all the 120 units. They must be taxed for the first 100 units. In fact the whole hue and cry for a drop is guided mostly by profit motive, the issue of investment may be an excuse. The nation would also like to know to what extent housing and car markets have contributed to the overall growth and welfare for the country.

The politics and economics of interest rate formation in this country must be studied carefully. Lowering interest rate raises stock prices in an environment where they themselves cannot move up thanks to fundamentals of the economy that are not conducive. It increases profits for those who have no inclination to spend extra for investment. It helps those who do not pay back loans, and taxes those who lend money to them. A lower interest rate on deposits in the banks is simply a tax on poor people. It goes without saying that nationalised banks, the major source of financing of business in this country, channelise funds of the poor to the rich. This has to be the outcome in an imperfect credit market where becoming a legitimate entrepreneur requires someone to be relatively affluent. The political implications of treating lenders as the children of a lesser god may not be as benign as thought by many.