Finance minister Arun Jaitley, understandably, wants lower interest rates and, given how banks are citing higher deposit rates for not being able to pass on RBI’s rate cuts, he has come down on high interest rates on term deposits. But more than anyone else, the government is to blame for this. In FY14, while CPI inflation was a high 8.4%, post office interest rates were in line with PPF at 8.6% and NSCs at 8.4%—naturally, bank deposit rates had to be high to compete with the post office. Indeed, with a 10.2% CPI in FY15, there was a fair degree of financial repression—keeping interest rates below inflation—since PPF rates rose to just 8.8% and NSCs to 8.6%. In FY15, however, while CPI collapsed to a mere 5.9%, PPF rates were cut to just 8.7% while senior citizen schemes paid 50bps more; in FY16, CPI fell further to 4.9% while PPF rates remained unchanged and those for senior citizens were actually raised 10bps. Even today, despite the government decision to reset rates more often, the PPF spread over CPI is well over 300bps, and is perhaps the single-biggest reason for higher interest rates across the economy—the policy of a spread over GSecs probably needs a re-look since the administered rates are way too high.
While this could well change if inflation rises, the only way Jaitley and the next RBI Governor—of the names being mentioned, Arvind Panagariya has been most vocal on the need for RBI to cut rates—can have sustained lower interest rates while also giving savers a fair deal by at least protecting capital values, is to keep inflation under tight control. Indeed, until the government does its bit to ensure there are no supply-side rigidities in the agriculture sector, a 50% weight for food in the CPI means inflation can spurt any moment—at that point of time, even an inflation-dove like Panagariya will have no option but to raise interest rates as a short-term measure.
What also needs to be kept in mind is that while lower interest rates are a good thing – subject to inflation being under control – there is a tendency to view them as a panacea for all problems. Lower interest rates, in themselves, are not going to stimulate investment activity at a time when, for instance, there is a 30% excess capacity in the system or when China, the biggest contributor to global growth, is in the kind of trouble it is in today. Indeed, one of the reasons why banks have not rushed to cut lending rates over the past year has been because there are few industrial takers for new loans—much better, the banks have argued, to use the extra headroom to rebuild their balance sheets a bit rather than pass on the rate cuts to existing borrowers. Eventually, of course, as the new RBI Governor will have to keep in mind, if inflation rises beyond a point, the rupee will depreciate and force FIIs to withdraw funds which, in turn, will necessitate a hike in interest rates. A fine balance between interest rates and inflation is critical, as is the government’s role in maintaining fiscal discipline and removing supply-side rigidities.
