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Interest rates: Is the UPA goofing up big time?

If Indian banks do not fix the right interest rates on deposits, they run the risk of dynamiting the social security of ordinary Indians.

Personally, I am spoilt for choice. Frankly, as a consumer, never in the past have I ever encountered something bigger, better and bizarre than this. Consider this: One car manufacturer offers to buy back the car that he sells to me now thirty-six months later at a pre-fixed price. Another gives me an equally titillating offer - buy now and begin paying EMI twelve months later. The third out did the first two - buy a luxury model and get a low end model absolutely free after five years.

According to press reports some leading manufacturers have over a month's inventory. In response, some are planning to suspend operations in some of their production units. Others have begun to work on a single shift. Even waiting lists have evaporated that popular models enjoyed not so long ago.

Surely, something has gone terribly wrong with our automobile industry.

The blood-letting within this industry will in probability be highly contagious. Surely, it is bound to spread shortly to other sectors too. If experts are to be believed consumer durables and non-durables are the next on the chopping block. Why is this happening? What is at the root of this conundrum? Is this merely an economic crisis that will find its automatic cure with mere passage of time? Or is there something structurally wrong within the Indian economy?

The stock markets suddenly seem to be revving with a possibility of a rate cut by the Reserve Bank of India . Apparently, for markets the Budget is dead and buried. And the expectation from RBI? Half a per cent at best; one-quarter of a per cent at worst. Intriguingly, this is touted as a miracle cure for all the ills plaguing the Indian economy.

Most in the North Block housing the finance ministry believe that at the root of the present crisis is the higher interest rates set by the RBI. This view is endorsed even by the finance minister. So do several analysts and economists. Naturally, several businessmen believe higher interest rate to be a villain of the piece. That explains the clamour for the reduction of interest rates across the nation.

But the moot question remains - will it work? Will it trigger demand? How will a rate cut of a mere quarter per cent entice customers when even these lucrative offers of the like mentioned above are unable to do so? Rate cut or no rate cut, won't the customer having tasted blood wait for another bout of car wars?

Needless to emphasise we are in "interesting" times.

Will rate cut trigger growth?
Come elections, politicians in most states in India make a standard promise - free power to farmers. Gullible farmers fall for this trap. Finding the offer irresistible they vote parties promising such outlandish ideas. Parties come to power backed on such promises without realising that even to this day India wastes 25 per cent of her power produced on transmission and distribution.

On top of it there is rampant corruption and thereby increasing the cost of power. All these are loaded on to the 75 per cent who are potentially billable. All this makes power costly in India. Given all this - where is the power to be distributed, much less freely to the farmers, in the first place? Yet, farmers believe they can get free power and with monstrous regularity vote for such outlandish promises.

One can possibly accuse the farmers of incapable of comprehending laws of economics. But can the same logic be held to our corporate, analysts and economists, especially on matters relating to interest rates? Simply put, has the RBI held the interest rate down - yes down - for too long? Did RBI artificially pin down the interest rates to benefit our corporate and stock markets? Is this not proving to be counter-productive?

The reason for the same is not far to seek. Lower interest rates, classical economists explain, boost current consumption while also shifting savings from bank deposits into stock markets. On both counts the biggest beneficiaries of such policies are large corporate. That explains the collective clamour of chambers of commerce in seeking rate cuts.

Alan Greenspan in his highly acclaimed book the Age of Turbulence goes on to explain how he as chairman of the US Federal Reserve cut interest rates in dealing with various economic crisis and instantly triggered growth. In a way he could afford to do so as Americans do not have much savings (barring the mandatory ones).

And wherever such savings existed, they were predominantly hooked on to the stock market. That explains, why rate cuts suited most Americans and how US economy responded to such rate cuts in the first place.

Readers must be aware that Americans depend on the savings of the rest of the world even for their domestic needs. In effect, a depression of its domestic interest rates benefits US, albeit at a tremendous cost to the rest of the world.

Is that why the response of the western world, notably that of the US, even to the LIBOR scandal tepid? Put bluntly, the question is whether LIBOR scandal a tacit blessings of the Western World?

But in India the situation is significantly different. In a country where there are millions of depositors, (aggregate deposits in our banks exceed Rs 65 lakh crore) - the quintessential saver - the standard practice in the past decade or so has been to shift the debate in favour of lower interest rates for the borrower. In the process little do we realise that we are hurting small savers to favour popular narratives, stock market sentiments and corporate honchos.

Is fixing lower interest rates by RBI the Indian version of LIBOR Scandal?

The non-negotiable laws of economics
Alan Greenspan in his above-mentioned work argued that only countries with an under-developed financial system and a primordial governance mechanism save. Developed countries like the US, he argued, need not save. And why should Americans do so when they have an elaborate state sponsored social security mechanism backed by a robust stock market?

In India, in the absence of a social security mechanism (and good governance including proper understanding of stock markets), bank savings has emerged as a viable, effective social security mechanism. Savings, in Indian context are an insurance against a rainy day - old age pension, health care, education for children and a host of other things all rolled into one.

Needless to emphasise, savings in banks are held by most as being liquid and absolutely reliable. This is one crucial differential that most analysts miss when it comes to dealing with rate cuts in India.

Consequently, lower interest rates robs the ordinary Indians of his returns, makes him unsure and consequentially nervous of his future. Naturally, when inflation overtakes interest rates he responds by improving his aggregate savings. This lowers consumption. Alternatively, he shifts savings from banks to avenues that offer better but safer returns. In the Indian context that happens to be gold where every roadside pawn shop happens to be an ATM.

That explains why savings rate in the economy has fallen from in excess of 37 per cent in 2007-08 to less than 30 per cent in 2012-13 with a concomitant shift to savings in physical assets like gold and real estate.

Either way, rates cuts beyond a point is counter-productive.

There is another dimension to this debate. Artificially lowering interest rates is nothing but mispricing of capital. This allows flab by way of excess capacity to accumulate within the economy. Factories were set anticipating demand at lower interest rates. But even a partial upward adjustment of interest rates in the past few years has dynamited the assiduously built plans of our corporate!

And the extant of crisis in the automobile industry mentioned above is the outcome of this mispricing of capital.

Corporate do not seem to realise this argument. Like the gullible farmers they believe that lower interest rate will instantly revive growth. Possibly a rate cut will improve the demand, marginally, not substantially. When car manufacturers are offering one car for one purchased, will a quarter per cent rate cut matter?

Strange as it may seem, if Indian banks do not fix the right interest rates on deposits, they run the risk of dynamiting the social security of ordinary Indians. Unless that is not addressed forthwith, Indians are not going to be confident of their future. A nervous Indian will not consume now. And till such time Indians regain their confidence, the economy will probably continue to be on a downward spiral.

Probably UPA under an economist PM does not realise that parking savings in banks is our version of social security, a privatised one at that. And for this reason cost of capital will be higher in India than elsewhere. And should UPA artificially attempt to suppress this, they will have lower interest rates but no capital at all!

Last modified on Sunday, 07 July 2013 07:36