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India is going through a slowdown, as 4% real interest rate is making people to go slow on consumption. The government’s need to cut down on fiscal deficit is also making Indian economy a higher taxed economy, thus affecting savings of the common man. Tarun critiques interest rates, in the weekly column, exclusively for Different Truths.
Interest rates are simple things, which one gains on bank deposits, debentures or private deposits. There can be compound interest also, which means interest generated on interest itself. Then we hear of interest rate that the banks charge on home loan, car loan, or credit card debt. There are interest charges on business loans or overdraft. Then there is discounting of the letter of credit or bill of exchange, which is another form of interest. There are the interbank rate, repo rate, reverse repo rate through which banks deal among themselves, or the reserve bank deals with the other banks in the system. This interest rate is the foundation of the whole banking system, one which drives the system. Let’s see how it affects the common man.
Interest rates are both a cause and effect of inflation. When inflation is high, central banks raise interest rates, to bring down inflation. Otherwise, the banks keep interest rate low, if inflation is low. In this way, buying activity in the economy is regulated by the central bank. However, interest rate works slowly, over a long period of time to change buying behaviour. This is because of time lag. The time lag is the time taken from the announcement of the policy to the time when its effect takes place. It is the interim period when adjustment is happening that the buying behaviour gets altered. That interim period gives us the real interest rates. The real interest rates are the central bank’s interest rates, adjusted for inflation. For example, if the bank interest rate is 6%, and inflation in the economy is 2%, then the real interest rate is 4%.
As we saw in my last column, negative interest rates stimulate the economy, at least over the short term, by enabling people to buy more. Now, consider the case where the interest rate is 1%, whereas inflation is 2%, then real interest rate would be -1%. In the USA, we see strong growth, because there, the real interest rate is nearly zero or negative.
In India, real interest rates are hovering between 3-4%. The Reserve Bank is not able to reduce interest rates much, because of the bad loans in the economy, and various other factors. So, the higher real interest rates are not stimulating the private investments and consumption.
Now, inflation is again dependent upon various factors. One of them is the demand for money in the economy. With fiscal deficit being low presently, the government is not really borrowing much through treasury bonds. Inflation also helps to allocate capital. As capital investment tends to gravitate towards the sector where inflation is high. Since inflation as a whole is low in the economy, private investment is also not taking place. Which means real interest rates would continue to remain higher until either the bank reduces the rate, or inflation starts to pick up. Let us see how consumption gets affected.
An individual, or household in macroeconomic terms, is basically a unit of the economic system. It is the price taker in the entire ecosystem, which means that the household can only accept prices in the economy, it cannot dictate them. The forces of aggregate demand and supply decide the prices. A household makes its decision to buy keeping in mind its need, as well as the buying behaviour honed over a number of years. This means that if a household is used to buying vegetables from a roadside vendor, then it won’t go to the supermarket to buy the same, anytime soon. Now, where does the interest rate fit into this scenario?
A household is a fast decision maker, as the buying is done by an individual in the household. If the real interest rates are high, then household would tend to curtail consumption, as the opportunity cost of buying goods would be higher. Whereas if the real interest rates tend towards zero, then the household would start to buy more, as saving money would not be as lucrative, so the time preference for consumption would force the consumer to buy. And so, the economy would start to boom.
Right now, India is going through a slowdown, as 4% real interest rate is making people go slow on consumption. The government’s need to cut down on fiscal deficit is also making Indian economy a higher taxed economy, thus affecting savings of the common man.
As India moves towards a more taxed and low deficit economy, the real interest rates are on an uptrend. There was a time when interest rates offered by banks was in the range of 12%, but the inflation also ranged at 9-10%. The real interest rates even at such high bank rates were about 2-3%. So, GDP growth remained on a higher path. One notable fact is that until 1990, the GDP was growing what was known as the Hindu rate of growth, or a very slow and stable rate. From 1990 onwards, the growth picked up, and India became a fast-paced economy, although we paid a price in terms of the higher fiscal deficit. Now the fiscal deficit is back in control, but, growth is also down. Now, India is no longer a deficit economy, as no more black market is there for electronic gadgets. License quota raj is also over. In fact, many of the goods are in surplus.
So, we see India has evolved a lot. But the best period is yet to come. The Indian consumer is highly intelligent. The consumer reacts to the changes in the economy, without being consciously aware of the real interest rates, or other such sophisticated concepts. These concepts are for the policymakers to follow. Right now, the need of the hour is to reduce real interest rates through a little government intervention. This will stimulate the economy. And the best way to do is, through lower taxes, and slightly higher fiscal deficit, rather than through lower bank interest rates. The higher fiscal deficit would reduce the real interest rates and would stimulate consumption in the economy.
In my next column, I shall write about the vast change Indian consumer has undergone over the last few years and some of the emerging trends. This helps the average businessman like me to plan my market offering.
©Tarun Gupta
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