Indexation Of Small Savings Holds The Key

In his article `Real interest rates and expectations' (February 10), Sudhir Mulji reiterates an important economic truth: `In the long run it is investment that drives income and savings'. He takes a view that the attack on provident funds and other forms of small-savings is in principle misdirected and that the real problem is the high lending rates in the economy.

The interest rate determines the cost of capital. As the interest rate is reduced, it is expected that the cost of capital would fall, inducing more investments. Is there a threshold level of reduction of interest rate to elicit the required reaction? Yes. Economic policy needs to be more aggressive than the reaction it seeks to elicit from the economic agents. This is because agents tend to wait when policy initiatives are implemented in a gradual phase. As a result of this rather long lag between the policy initiation time and the expected time of reaction from the agents, the authorities are led to conclude that the policy initiative was a failure and refrain from implementing such measures further. Therefore, reduction of interest rate per se may not result in the desired reaction from economic agents immediately. What is important is reduction by a substantial amount. But by how much?

 

Investors may continue to invest in the economy even when interest rates are high, only if the returns are higher. Such high returns seem unlikely in the current scenario, except in a few sectors such as information technology, which substantially relies on the sustained growth of economies outside India. The Indian economy is being progressively liberalised; competition, both domestic and foreign, is expected to keep pressure on output prices in the manufactured goods sector. Therefore, it appears that given the current economic environment, it is higher interest rates that deter investments. The discussion on prices leads us to the topic of inflation, and to the debate on which is the relevant rate of inflation in computing real interest rate.

In the context of return on investments, the relevant rate of inflation is the wholesale price index (WPI) since it affects manufacturers who invariably supply their output and purchase their inputs in the wholesale market. WPI on the whole may not be relevant if we consider the fact that inflation in manufactured goods has been far less compared to that in the primary goods. The Economic Survey 1998-99 indicates that food articles contributed the major share (47 per cent) of annual growth in inflation during the peak of inflation (September 1998). The overall share of primary articles in inflation was at 60.9 per cent. Therefore, in evaluating the real cost of capital for industry, it is pertinent to consider the inflation in manufactured products rather than the overall inflation.

To sum up, on the one hand, the high lending rate has kept the cost of capital high; on the other hand, we have a continuous low inflation in the manufactured products segment. Even if the economy accelerates and demand picks up, prices of manufactured goods cannot be expected to increase substantially due to internal competition and competition from global players in the context of falling tariff rates. This results in low expected rate of realisations. Hence it is correct to say that the real problem is high lending rates in the economy, which deters investments and employment.

However, the question how to reduce lending rates still remains unanswered. It is in this context that the reduction in the interest rate offered on small savings and provident funds do matter. Any cut in the lending rates by financial intermediaries must be preceded by a cut in deposit rates. This will not be possible as long as the government continues to offer high interest rates on small savings and provident fund schemes along with tax advantages. Therefore, any attempt to reduce lending rates in India has to be accompanied by a substantial reduction in interest rates on small and provident fund schemes.

Two immediate questions arise on such a move. First is the impact on the savings rate and second, the plight of the salaried middle income class who will get very low real returns, given the danger that inflation may shoot up in the future.

A significant part of the savings mobilised from these sources are not dependent on interest rate but on the tax savings that these schemes offer. Moreover, a significant portion of contributions to the provident funds is compulsory in nature. For the tax savers, alternative schemes such as infrastructure bonds and mutual funds have now come. Therefore, a significant reduction in interest rates need not transform into a fall in the savings rate.

But a significant reduction in interest rates will have an impact on the savers' real returns. Consumer prices have been volatile in India and the real returns available to the savers, particularly the middle income and the low-income groups, will be very small and may even turn negative.

The only solution in such a scenario is to index the interest rate on small savings and provident funds to the inflation rate, such that investors will be assured a rate of return greater than the inflation they suffer. Here, the relevant rate must be the consumer price index (CPI). However, the issue of different geographical locations having different CPI has to be sorted out.

Since its interest expenses are linked to inflation, the government will now be more concerned about containing inflation. It will be concerned about reducing the fiscal deficit as deficits are inflationary, remove structural inefficiencies and bottlenecks that fuel inflation and seriously address the volatility of agricultural output that happens to be a major contributor of volatility in consumer prices. Thus, in the long run, the fiscal policy will be able to co-operate with the monetary policy in containing inflation.

(The author is a consultant with the Business Intelligence Unit, Chennai.)