Cheap capital can't happen now but the PPF rate cut is the right step in that direction
If finance minister Yashwant Sinha thinks he's got a thankless job on hand, he can't be blamed. For, when the finance ministry reduced interest rates on the public provident fund (PPF), National Savings Schemes and post office deposits on January 14, he probably thought he could step forward and accept the hosannas. Well, he did get a couple of claps, but that's about it.
Most looked at this move more as a tentative beginning brought about by fiscal and economic growth compulsions and not for reasons that should actually cause a reduction in interest rates: helping Indian industry achieve global competitiveness by reducing the cost of capital. That will now happen if the rbi reduces the rate at which banks borrow from each other, reducing their cost of capital and enabling them to reduce lending rates, thus making capital cheaper for industry. And the rbi can only reduce the rate if small savings rates are down significantly.
So, what has the government done? It has reduced interest rates on PPF and post office schemes by a single percentage point each (see chart). It has also decided to transfer 80 per cent of the small savings to the states, up from 75 per cent all this while, so that states can't complain. Additionally, the Centre has brought down the lending rates to states from 13.5 per cent to 12.5 per cent while effecting the rate reduction. Last year, the government had reduced interest rates by half a percentage point on all small savings schemes except PPF.
Doesn't a cut in the small savings rate hurt the interests of small savers, who form a large part of the population? No, says D.H. Pai Panandiker, noted economist and advisor to the RPG group. "It doesn't really affect a large section because PPF is used more as a tax-saving measure by the upper-middle class. Besides, real interest rates (interest rate minus inflation as measured by wholesale prices) are at their highest ever at 9 per cent now, with inflation down to 2 per cent. So, PPF and other small savings instruments are still a very lucrative option." With the result, the interest rate cut is not likely to reduce savings in these schemes.
While it doesn't hurt small savers in real terms, the rate cut helps the government by containing the fiscal deficit. The number-crunchers are still to provide accurate figures but back-of-the-envelope calculations indicate that the government could save between Rs 700 crore and Rs 1,000 crore by virtue of lower interest rate costs in 2000-01. Hear Pai Panandiker: "Small savings this year are expected to amount to about Rs 40,000 crore. Reduce interest payment on average by one percentage point and the government saves Rs 400 crore. Plus, if the bank rate is cut by half a percentage point (which is expected soon), the government saves another Rs 300 crore on its approximately Rs 65,000-crore borrowing programme."
The government also believes that this rate cut will spur industrial growth though, most outside it are sceptical of the efficacy of a half per cent bank rate cut. Says economist Surjit S. Bhalla: "The manufacturing index in November 1999 went up by only 3.5 per cent, while for April-November 1999, the growth stands at 5.7 per cent. These figures have scared the government, for if you want the economy to grow, it is not possible with such high interest rates." But such a marginal cut doesn't lead to what interest rate cuts are ideally expected to achieve for the economy: low capital costs. Adds Bhalla: "We can't be a competitive economy if borrowing rates are more than 5-6 per cent. Blue-chip firms in the US borrow at 3.5 per cent real interest rates. In India, real interest rates are in double digits. A 1 percentage point interest rate cut can't possibly make us competitive."
Neither does such a cut in small savings divert more money to the stockmarket to be used by industry to invest in new projects. Says Prithvi Haldea, managing director, Prime Database, India's premier database on the capital markets: "Small savers are risk-averse people who invest in these schemes for tax-planning purposes. They aren't equity investors. Even if the rate reduction was higher, it wouldn't have diverted these people to the stockmarkets. Some money may flow to the mutual funds, though." That is why Sinha will have to contend himself with a few stray claps for the moment.
Ideally, the government should be looking to use the low-inflation regime as a reason to cut interest rates further, but has instead taken this course more as a desperate measure. Says Pai Panandiker: "Till November last year, that is in the first seven months of 1999-2000, the government had collected only 48 per cent of the tax revenue target. At the same time, it had incurred about 60 per cent of its budgeted expenditure, resulting in a 71 per cent fulfilment of the budgeted fiscal deficit. The government clearly needed to cut expenditure in many areas, which it has now done by reducing its interest rate on borrowings." Since such a small step won't be enough to give the required boost to industrial growth, that's about as much help the government can expect in balancing its budget.
Some experts also contend that for some time now, the government has had the opportunity to use the inflation rate to bring down the nominal rate of interest, because the real interest rate was always high. Contends Bhalla: "It is a myth that inflation has come down only in the last year. Barring '98's onion-related inflation, the Wholesale Price Index has been low for the last four years." He backs his claim with hard numbers. Between 1996 and 1999, the average inflation rate has been 5.3 per cent, while the average prime lending rate has stood at 13.75 per cent. That means a real prime lending rate of a whopping 8.45 per cent. Contrast these hard statistics with the 3.5 per cent figure in the US. Little wonder then that Indian industry has suffered. Over the last four years, the manufacturing index has grown by 6.225 per cent. Clearly, industry could have done with some cheap funds.
Bhalla expected small savings rates to be cut further last year, but it didn't happen. He's bullish again. "I expect a minimum 1 percentage point cut very soon, and a further three points by March 2001." What makes him so optimistic? He, along with most other economists, expects inflation to remain low, if not decline further, giving the government adequate opportunity to cut nominal interest rates again, because the real rate will remain high. Also, inflation rates are extremely low worldwide, and Indian trade has integrated itself adequately with the world market. Therefore, there is now a linkage between global inflation rates and prices in India. Now, if there are any supply shortages in India, goods can always be brought in from abroad where prices are low.
While the opportunity definitely exists, four percentage points will probably sound a bit too drastic for most. But even if the government gets halfway there, it would move ahead a fair bit.
Economists believe that further interest rate reductions can only happen if the finance ministry gives up its power of setting interest rates for small savings. "Interest rates should be determined by demand and supply. It should be the Reserve Bank of India that sets the bank rate and the ministry of finance should give up its authority of setting small savings rate." In other words, depoliticise the process of interest rate adjustment. Only then can India move towards becoming a globally competitive economy, and Sinha can truly accept his hosannas.