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Interest Rate Economy

Don’t Punish People Who Save

By Dr. Vinod Mehta

The slashing of interest rates on various saving instruments initiated in 2000 by the, then, Government continues till date. The interest rate on savings bank deposit has been slashed from 4.5 per cent to 3.5 per cent. The interest rate on public provident fund (PPF) as well as on GPF has been progressively reduced from 12 per cent to 8 per cent. The interest rates on bank fixed deposits as well as on Government bonds have almost been halved in the past five years. The latest in the series is the abolition of bonus on Post Office monthly income deposits.

The industry has been hailing these steps for the simple reason that the Government has been accepting their demands relating to the reduction in interest rates as they have all along been arguing that the cost of borrowing is higher in India. Similarly, it also meets the Government’s desire to reduce its debt burden.

In other words, the Government has accepted, on the one hand the long standing argument of the industry that the high interest rates are coming in the way of industrial expansion and, on the other hand, its own desire to reduce debt burden. It has also been argued that the reduction in interest rates will spur the economic activity and reduce Government deficit. Whether it will actually lead to such results one has to wait and watch.

However, going by past experience, it is highly unlikely that it will really lead to any significant expansion in the economic activity. Whatever buoyancy is being seen in the economy is due to factors other than reduction in interest rates. On the face of it the argument that the economic activity is not expanding because of the high interest rates is doubtful. Interest payment is only one component of the total cost of production. The cost of other factors of production like labour and materials is much higher.

But these countries never argued that the wages and cost of materials be brought down to make their product competitive. Therefore, to argue that interest rates in India are higher than interest rates in other countries and for that reason our production costs are relatively high do not carry much weight as the relatively cheap labour and cheap raw material offset the disadvantage of high interest rates. India as the cheap interest rates offset the disadvantage of expensive labour and raw material in the developed countries.

The real reason for asking downward revision of interest rates is that the Indian industry, even after 15 years of economic reforms, has not yet been able to gear itself to make efficient use of all the resources, as the foreign industry has. They are not yet aware of the need to use economically the available resources including the borrowed funds. In fact, a large number of our companies are in the habit of diverting the borrowed funds into unrelated channels or activities and because of their ability to window dress their balance sheet, this diversion of funds are rarely detected. For instance, the money borrowed from banks to meet the short term working capital needs are many a times used to make speculative purchases at the bourses.

Therefore, it is difficult to say that the increased availability of funds at reduced interest rates will give a big push to the industrial activity in the country. It is likely that a large part of borrowed money will either be diverted to other unrelated activities to make short-term speculative gains or it will be used to retire the high cost debts raised earlier; it will seldom be used for expansion activity.

In fact, the downward pressure on interest rates is also due to the convergence of interests of the Government and industrialists. It is common knowledge that the Government is the largest borrower of funds in the country. PPF, GPF and EPF as well as terms deposits with post office funds which are savings for an average citizen are in fact public borrowing by the Government; the funds collected through GPF, PPF, EPF and post office deposits go directly to the Government account. Apart from these direct borrowings, the Government also borrows from commercial banks through the medium of short-term and long-term bonds etc. to meet its current expenditure.

These borrowings and interest payments over the years have accumulated so much that the government is almost caught in a debt trap wherein it has been borrowing to repay its earlier loans. Therefore, the government has also been very keen to reduce the interest rates as it will reduce the cost of public borrowing to the government. One percentage point reduction in interest rates on PPF, GPF etc. and new bonds will result in savings of thousands of crores rupees on Government borrowing. This one reason was sure enough to bring down the interest rates continuously.

As in any game there are always some winners and some losers. In this game of interest rate cut the winners are the industrialists and the Government, while losers are the average citizens who save money for their future needs and for their old age. The reduction in interest rate while reducing the cost of borrowing to the industries and government will in effect reduce the earnings on savings of the general public. The sufferers are pensioners, the old people, the widows and others who are solely dependent upon interest earnings of their savings. The younger people may also feel that their savings are not growing as fast they should. It is likely that the aggregate domestic savings over a period of time may also go down as some people may not find it attractive to save in the banks.

In India, provident fund and term deposits in banks are the major forms of savings as both the capital market and mutual fund sector are not highly developed. In developed countries people invest their savings either in equities, in mutual funds or in pension funds which give them a relatively very high rate of return, much higher than the interest rates on term deposit in the banks. In India both the primary and secondary capital markets are highly manipulated by speculators and therefore the equity market has not been able to become an alternative to savings in the banks for a large number of people.

Similarly, the mutual funds sector is again highly dependent upon the volatile capital market and therefore cannot assure a steady and growing rate of return on investments in mutual funds. Had there been a transparent equity and mutual fund market, people could have diverted their funds from banks to these institutions. Since these sectors are highly manipulated, the Indian saver is condemned to keep his surplus money in banks (or invest it in gold and real estates) which offer a relatively low rate of return.

The most important question, however, is that why should Reserve Bank of India dictate the savings bank rate to the banking industry in this era of liberalization. Like any other central bank it should only fix the bank rate and free all other interest rates including the savings bank rate to be determined by the demand and supply of funds. By imposing savings bank interest rates it is forcing the banks to adopt a similar pattern of interest rate structure. The move apparently is to protect the interests of the weaker banks. If the Reserve Bank of India were to free the savings bank rate of interest, there would be many efficient banks which would be willing to give a higher rate of interest than the one fixed by the RBI. Similarly, the efficiently run banks would also be in a position to offer higher rates of interest on term deposits also.

Therefore, when we are talking of financial sector reform, it is high time that the Reserve Bank of India limits itself to fixing the bank rate as well as the CRR and let market forces of demand and supply for funds determine the interest rates on various instruments savings including the savings bank deposit rate. If the demand and supply conditions require the savings bank interest rates be below 4% or be above 4% then let it be so.

Let the saving public decide in whatever form it would like to keep its savings depending upon the rate of interest being offered by various banks on various kinds of savings instruments. At the same time the rate of interest on provident funds including Post Office deposits should not be reduced below eight per cent so long as the pension funds as also mutual funds are not placed on strong footing. Reduce your debt burden, help reduce production costs but do not punish the savers especially the pensioners, old people, widows etc. –INFA

(Copyright, India News and Feature Alliance)

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