»Vivek Kaul's Diary

Interest Rates: Depositors Cannot Match Decibel Capacity of Big Business
4 AUGUST 2016


On August 9, 2016, the outgoing Reserve Bank of India(RBI) governor Raghuram Rajan, will present his last monetary policy statement.

Indications are that Rajan may not cut the repo rate. This, for the simple reason that the difference between the repo rate and the rate of inflation as measured by the consumer price index has narrowed since June 7, 2016, when the last monetary policy statement was presented. The repo rate is the rate of interest that the RBI charges banks when they borrow from it, on an overnight basis.

The last monetary policy statement was presented on June 7, 2016. The RBI had held the repo rate steady at 6.5 per cent. While presenting the June 2016 policy, the RBI was looking at the rate of inflation as measured by the consumer price index, for the month of April 2016. In April 2016, the rate of inflation rose to 5.39 per cent, in comparison to 4.83 per cent in March 2016.

The difference between the repo rate and the rate of inflation stood at around 111 basis points (6.5 percent minus 5.39 per cent). One basis point is one hundredth of a percentage. As governor Rajan said in the monetary policy statement: "Retail inflation measured by the consumer price index (CPI) rose more sharply than expected due to a more-than-seasonal jump in food prices...CPI inflation excluding food and fuel edged up in April, driven by prices of petrol and diesel embedded in transport and communication. Clothing and footwear also registered moderate increases in inflation. Services inflation remained elevated on account of house rents, water charges, tuition fees and taxi/auto fares. Excluding petrol and diesel from this category, inflation was sticky and above 5 per cent."

In the monetary policy to be presented next week, the RBI is likely to look at the inflation as measured by the consumer price index for the month of June 2016. In June 2016, the rate of inflation stood at 5.77 per cent against 5.76 per cent in in May 2016.

This means that the difference between the repo rate and the rate of inflation has narrowed to 73 basis points (6.5 per cent minus 5.77 per cent) against the 111 basis points earlier. In this scenario, it is highly unlikely if Rajan will cut the repo rate. My guess is that if it wasn't Rajan's last monetary policy, he would have raised the repo rate. But that is something that he is likely to leave to his successor.

Meanwhile, as the monetary policy approaches next week, you are likely to see big business represented by lobbies like CII, FICCI and ASSOCHAM, demanding lower interest rates. Lobbies like CREDAI, which represent real estate companies are likely to do the same. If Rajan does not cut the repo rate, such statements will be made after August 9, 2016, as well. If he does cut the repo rate, big business will say that further cuts are required.

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This will happen because there is a great belief among these companies that lower interest rates lead to faster economic growth. Of course, as I have often explained in the past, the relationship between interest rates and economic growth is not as simplistic as big business makes it out to be.

Further, big business in India is currently highly leveraged (i.e. it has borrowed much more than it is in a position to repay. It is also finding it difficult to keep paying the interest on the debt that it has taken on). In this scenario, it needs lower interest rates. But lower interest rates hurt crores of depositors who have invested their money in fixed deposits.

As D Subbarao, former governor of the Reserve Bank of India, writes in Who Moved My Interest Rate?-Leading the Reserve Bank of India Through Five Turbulent Years: "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."

While there is nothing wrong in the big business lobbying in favour of something that works well for it, it is clearly not a level playing field that we are talking about in this case. 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."

Also, rising prices bring down the real rate of return on fixed deposits. The real rate of return on fixed deposits is the nominal rate of interest on fixed deposits minus the prevailing rate of inflation. This hurts the older lot which depend on fixed deposits to meet their regular income. It also hurts the younger lot which uses fixed deposits to create a corpus for their future. This can be for the education of their children or to set aside some money for their retirement. This could lead to the young putting aside a higher amount of money to save for the future, and in the process bring down their consumption.

Lower real interest rates hurt those dependent on fixed deposits either for a regular income or to create corpus for the future. Further, unlike the big business, depositors are not organised to lobby what is good for them.

As Subbarao writes: "The business sector is organized, has a platform for voicing its demand and even has an opportunity to present its point of view to the governor in the pre-policy consultation meeting. On the other hand, the large majority of the public that is hurting under inflation is scattered and unorganized, has no avenue to voice its concern and does not even have the privilege of a pre-policy meeting with the governor."

And since this lot is unorganized, there is an obligation on the RBI "to bend over backwards to listen to this voice of silence". Governor Rajan hasn't disappointed on this front up until now. Chances are he won't even with his last monetary policy statement scheduled for next week.

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