The interest rate question

With inflation at fairly low levels, businesses find interest rates too high.  So do a third of the home loan borrowers in surveys. Given the increasingly vociferous demands for the Reserve Bank of India (RBI) to reduce rates of interest, the suspense surrounding the outcome of the fourth bi-monthly meeting of its Monetary Policy Committee (MPC) ending on Wednesday is palpable.

The real rate of interest is the nominal rate of interest adjusted for inflation. It indicates the real return to a lender after accounting for the change in the value of money. Given the diversity of rates of interest with variations in loan maturity and borrowers’ risk profile, often the proxy for “the interest rate” is taken as the rate on long-term sovereign bonds carrying negligible risks.

Like the rates of interest, there are many measures of inflation, such as in terms of wholesale prices and gross domestic product deflator. In the ultimate analysis, all economic activity is for sustaining consumption. Thus, for measuring the real rate of interest, inflation may be taken as that measured by the consumer price index (CPI). Although expected inflation may be more relevant, with difficulties in measuring expectations, the nominal rate of interest may be adjusted by CPI inflation prevailing on the relevant date to calculate the real rate of interest.

So, how high is the “real” rate of interest in India? The annual real rate of interest on 10-year Government of India bonds rose from less than 1 per cent in August 2016 to a peak of over 6 per cent in June 2017 before declining to less than 5 per cent in the subsequent two months. According to OECD data, since October 2016, the Indian real rate has been considerably higher than in G-7 countries — that is, Canada, France, Germany, Italy, Japan, the UK and USA. 

Illustration by Binay Sinha
Is a real rate of interest of 5 per cent too high for India? India is a developing country with scarcity of capital, and this scarcity should be reflected in a higher real rate of interest than in developed countries. But, “how high”?

From October 2016 to July 2017, on average, the real interest rate in India was 4.48 per cent relative to -0.16 per cent in the G-7 countries. However, the G-7 average conceals considerable variation across countries reflecting their different economic situations. It is interesting to note that, across the Euro Zone countries using the same euro as their currency, with arbitrage threatening to wipe any differences away, the nominal interest rates for government bonds or blue chip corporate loans are usually similar. Yet, the real rates of interest vary significantly.  For example, during October 2016 to July 2017, the average rate in Germany was 2.4 percentage points lower than Italy’s, which itself was 3.4 percentage points lower than India’s.  

When things settle down in equilibrium, economists agree, the real rate of interest reflects the balance of thrift and productivity. From the productivity side, two important factors are the availability of labour relative to capital and stock market returns. Both tend to increase the demand for investment and hence the real rate.  From the thrift side, declining savings rate, including that of the government, contribute to high real rates. As productivity and thrift change over time, so does the real rate of interest. For example, in G-7 countries, its broad trend since the early 1960s has been of a decline extending until the mid-1970s, then an increase until the late 1980s, before a decline again since the late 1980s.

With capital flows across countries, the real rate is no longer dependent only on domestic factors.  A country with a higher real rate will attract capital flows and experience a decline in the rate itself.  Yet, in the short run, the real rate can differ across countries.  

So, what should the real rate of interest in India be in the current circumstances?  At the end of the 19th century, the famous Swedish economist Knut Wicksell had pointed out that an economy has a “natural rate of interest” that allows the economy to operate at its full potential output with price stability. If the natural rate is higher than the real rate of interest, prices fall and vice versa.  So, what is the elusive Indian ‘natural rate of interest’?

In 2014, former RBI governor Raghuram Rajan had described a real long-term risk-free rate between 1.5 per cent and 2 per cent to be “reasonable”. Later, some ambiguity arose whether this 1.5-2 per cent applied to the long-term (10-year) government bond rate, the one-year Treasury bill rate or the repo rate. In September 2017, these three rates were in the range of 6 per cent to 6.7 per cent. Assuming that CPI inflation in September 2017 remained unchanged at previous month’s 3.36 per cent, the real rate in September was between 2.6 per cent and 3.3 per cent. Thus, unless the MPC believes that inflation expectations are considerably higher than 3.36 per cent, there is scope for a reduction of 100 basis points for better alignment of the policy rate with the natural rate of interest.

Indeed, a reduction in the repo rate will encourage banks to buy more government bonds and thus reduce the interest cost of new public debt that the government contracts. Banks will also benefit from the appreciation of the marked-to-market value of existing public debt with higher coupon rates in their books. But it is doubtful that, without supporting measures, the flow of bank credit to the private sector will improve. The market for bank credit to the private sector has been affected not so much by mis-pricing of credit as by more fundamental factors such as stalled big-ticket infrastructure projects and over-leveraged borrowers’ balance sheets.

It is also important to remember that, from the early 1960s, for three decades, the real rate of interest was often negative under the administered interest rate regime.  It did more harm than good to the economy. Furthermore, a decline in the real rate of interest will also affect the savers, including the small savers. Thus, even if a reduction in policy rate comes, it will be important to manage expectations about its effects. 

The writer is an economist

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