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Time for interest rate arithmetic - Outside View by S.S. TARAPORE

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Time for interest rate arithmetic
Apr 6, 2015

The Reserve Bank of India (RBI) Governor, Dr Raghuram Rajan, will unveil the First Bi-Monthly Monetary Policy Review for 2015-16 on April 7, 2015. Unlike in the 1980s, when RBI policy announcements were treated as arcane communications between the RBI and the banks, in the present milieu, economic agents await the policy announcement with bated breath. With six policy reviews in a year and also off-scheduled policy announcements, the RBI's monetary policy receives perennial attention. Close to the policy dates, there are pronouncements by top government honchos, leading industrialists, economists, bankers, analysts and opinion makers. Powerful lobbies argue forcefully on the need for lower interest rates. In India, there is widespread and misplaced preference for lower interest rates. This results in a distinct bias in favour of borrowers and against depositors.

There is a grossly erroneous viewpoint that for high real rates of growth, all that is required is large amounts of credit at low rates of interest. The arithmetic of how interest rate changes affect borrowers and depositors is set out below.

Arithmetic of borrowers

Let us assume that the cost of production is Rs 100 and interest cost is Rs 10 (i.e. an interest rate of 10 per cent). When the cost of borrowing goes down by one percentage point, overall cost of production goes down by 0.10 per cent (as interest cost is 10 per cent of total costs).

Now let us take the case of an industry which is borrowing-intensive, where interest accounts for 50 per cent of total costs. In such a case, a one percentage point reduction in interest rates results in a 0.50 percentage point reduction in the cost of production. Thus, the argument that the interest burden explains why Indian industry is uncompetitive is totally erroneous.

Arithmetic of depositors' income

Illustratively, let us assume that the deposit rate is 10 per cent and the depositor's total income is Rs 100. A one percentage point reduction in the deposit rate would reduce the depositor's income by Rs 10 and as such, the depositor's total income will fall to Rs 90. Thus, a one percentage point reduction in deposit rates adversely affects depositors to a larger extent, while the borrower gets very minimal relief in terms of reduced cost of production.

International comparisons

It is often articulated that producers in industrial countries pay low nominal rates of interest, while in India, producers pay much higher nominal rates of interest. An appropriate comparison should be in terms of real rates of interest (i.e. nominal rate of interest minus the inflation rate). Moreover, in a capital-short economy like India, it is necessary to have distinctly higher real rates of interest than in the industrial countries. A major distortion in India is that given the available factor proportions of labour and capital, we invariably price capital too low and this distorts the natural factor proportions of labour and capital.

Exchange Rate and Competitiveness of Exports

It is clear that with the overvaluation of the rupee, Indian exports are progressively becoming uncompetitive. Micro, small and medium industry predominate in the export sector and it is precisely these smaller units which are vulnerable and are adversely affected by the over valuation of the rupee.

In the recent period, there is a resurgence in demands for an interest rate subsidy for export credit. As illustrated above, a reduction in interest costs adds very little to competitiveness of industry. Moreover, the track record of the government in paying the export subsidy is far from satisfactory. Invariably, there are disputes on the calculation of the export subsidy and when government finances are under strain, there are delays in payment of subsidy and in some cases, subsidy is denied. It is amply clear that an interest rate subsidy on export credit is no effective substitute for an overvalued rupee. The decided preference for an overvalued rupee reflects the power of large industry, which is largely import intensive as also our false sense of machismo that a strong rupee reflects the strength of the nation. The history of development of the Emerging Market Economies (EMEs) is that an undervalued exchange rate has given a strong thrust to export led development.

Capital inflows and exchange rate

Capital inflows have been strong in the recent period and are likely to continue. Allowing the rupee to appreciate may be prima facie considered as an anti-inflationary measure, but this is deceptive. The overvalued exchange rate, when eventually corrected, would dislocate the system. Hence, the appropriate policy response is to build up forex reserves if the inflows are large and the appreciation of the rupee is avoided. The consequent increase in liquidity can always be mopped up by open market operations and Market Stabilisation Securities (MSS). The government and the RBI have enough experience of handling such operations Depositors' response

It is sometimes argued that depositors are trapped and they have nowhere to go and, therefore, would meekly part with their savings at any level of deposit rates. This is dangerous thinking. With inadequate rates of return, domestic savings have fallen precipitously during the past few years. Beyond a critical point, depositors will not tolerate an erosion of their income and will migrate to riskier financial and physical assets; this would destabilise the financial system. Depositors have provided yeoman service to the country and any further reduction in interest rates is best avoided.

Note: This article was first published in The Freepress Journal on April 06, 2015. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.

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