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Saturday, Feb 16, 2002

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What should the interest policy be?

P. R. Brahmananda

AS Budget day approaches, speculation is rife regarding the interest policy to be announced by the Finance Minister, Mr Yashwant Sinha, and the Reserve Bank of India. The corporate sector has been demanding a further cut in interest rates. The Y. V. Reddy Committee, it seems, has prepared the ground for an interest rate policy that could take rates further downward. The financial press, which is largely a part of the corporate business sector, is naturally pressing for further cuts in interest rates.

The RBI has been purchasing dollars from the market in such quantities as would lead to larger and larger liquidity in terms of rupee stocks in currency and deposits. The banks, flush with funds, are buying government securities in such quantities as are fast bringing down the yields. The Finance Minister himself, known as a great cheap-money enthusiast, has been creating a background situation conducive for him to push the rates down further.

Let us look at what is happening to the sequential five-year trend rates in several sets of prices. The set includes the wholesale price index, the working class consumer price index, the non-manual labour price index, and the agricultural labour price index. Five-year sequential trends from 1980-81 onwards have been computed for all these prices series. Graph 1 gives the course of these trends for all the four prices series.

In the early 1980s the trend rates for all the series were quite high. That was the period of the second major oil price-rise (oil-shock). From the mid-1980s or so, the trend rates of the prices series started declining, the wholesale prices series and the agricultural labour prices series dipping faster than the two mostly urban consumer prices series.

But from the late 1980s, partly because of the Gulf War shock and its effects on oil prices, the trend rates of rise of all started moving up, and this upward drift continued till about 1993-94. Thereafter, the trend rates of rise of the price series started dropping; the fastest downward rate of drift being in the wholesale prices and agricultural labour prices indices. In 2000- 01, the wholesale price index had a five-year trend rate of rise of 4.94 per cent. The agricultural labour prices index had a five-year trend rate of rise of 4.98 per cent.

The working class consumer prices index had a trend rate of rise of 6.79 per cent and the urban non-manual labour prices index 6.9 per cent. There is clearly about 2 percentage-point difference between the trend rates of rise of wholesale prices and agricultural labour prices, and the two consumer price series. A geometric mean of the trend rates of rise of the four price series was worked out. In 2000-01, the geometric mean of the trend rates of rise of the four prices was 5.8 per cent. (excluding the trend rate of rise of wholesale prices, the geometric mean of the trend rate of rise of the other three prices series was 6.2 per cent in 2000-01.)

According to theory, one proxy for the expected rate of inflation is the trend rate of rise in prices for the last five-year period. The second proxy is to project the price series for the next five years on the basis of the trend rate of rise for 2000-01. This means we have to ascertain the trend rate of the price series trend rate itself.

We have tried to do this, and find that the geometric mean of the four price trend rates of rise would come down to about 3.4 per cent by 2005-06, if we assume that prices will go on falling at the trend rate of fall referred to above. But, we do not know whether the geometric mean of the price series will go on falling in the above manner and the above rate.

Again, according to theory, the real rate of interest is approximately equal to the trend growth rate of the economy. We have worked out the five-year sequential trend rates of growth in NDP at constant factor cost, from 1980-81 to 2000-01. Some may argue that the real rate should be below the trend rate of growth, and others that it should be higher than the trend rate of growth.

If we want different income classes to be treated equally, the trend rate of growth would be a good proxy for the expected rate of growth. But if the growth rate is falling, it is possible that the future trend growth rates will be lower than the current ones. The trend rate of growth was below 3 per cent in the early 1980s. By the early 1980s, it was above 6 per cent. But it started falling from 1997-98 and is now about 5.4 per cent — that is, the current five-year sequential rate trend is 5.4 per cent.

We expect that the Government would like to move the growth rate upwards in the future. It is, therefore, not sound to assume that the growth rate trend will keep falling in the future. Graph 2 depicts the course of the geometric mean of trend rates of rise in the four price series, the five-year sequential trend growth rates in real NDP and the course of the theoretical or normative nominal interest rate on five-year bonds. (The theoretical or nominal rate is obtained by multiplying the geometric mean of the trend rates of rise in prices and growth of real NDP.)

If the authorities, the Finance Ministry and the RBI follow theory, the nominal rate currently on five-year bonds should be around 11.6 per cent. But if they extrapolate the falling trend rate of rise in the geometric mean of price series and place the relevant future trend rate of rise in prices at 4 per cent, and if they do not expect the growth rate trend to fall below 5 per cent in the future, the relevant normative or theoretical nominal interest rate currently should be placed around 9 per cent.

If scrips are not liquid or not marketable, as in the case of the PPF and PF, I would suggest that the interest rate should be fixed at 9.5 per cent or so. A further reduction would not be advisable. Most fixed deposits of three years and above have a rate around 9 per cent or so. There is no reason why this should be changed. The PPF and PF are special categories of savings instruments where there are lock-in periods or withdrawal of amounts is subject to time constraints. They are more like pure savings instruments. But several other savings items may be kept at 8-9 per cent. It may be asked whether the savings yields should not be linked to yields on government securities. Let us note that the yields here are not determined by the market. They are affected by the liquidity policies of the authorities. Often, the banks have no alternative but to lodge their funds in government securities.

Once the economy picks up, they may have more alternatives. It is well known that by flooding the market with liquidity, a central bank can bring down the nominal yields by a substantial extent and, when this happens, it would not be proper to treat them as norms. Further, the very liquid nature of government bonds makes them different from PPF, PF and fbank FDs.

May I submit that the crisis in the mutual funds industry, including in the UTI, is primarily because of the policy of forcing down yields followed by the authorities. In fact, the current fall in velocity has a lot to do with the uncertainties generated about the market for assets, because of the current policies.

Maybe we should return to the policies and perspectives of the Manmohan-Rangarajan period to revive savings and investments, which are now at a low ebb. The Finance Minister must ask himself why the economy has underperformed during the last three-four years. Probably because of departing from past policies.

Even now, it is not too late to return to the successful path followed by Dr Manmohan Singh and others. There is no advantage in being different for the sake of difference. The economy is being hurt and it is time a rethinking took place. No poor economy can consume its way to prosperity.

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