Low interest rate: Incentive and subsidy

“It was the best of times, it was the worst of times …” Charles Dickens

Low interest rates are a big boon for borrowers. However, they are a serious problem for savers. Low interest rates are supposed to act as an incentive for real investment and, relatedly, the revival of the economy. However, real investment is often not very responsive to interest rate cuts when we have an economic slowdown. So, some of the benefit due to a low interest rate policy is not an incentive; it is a subsidy. 

Consider, for example, the homebuyers. A stylised fact is that home prices have been somewhat sluggish over the last six to eight years while income has been steadily rising, except for some change due to Covid-19. So, affordability has definitely been increasing. Home buying would have picked up substantially anyway. Under these circumstances, the low interest rate policy was not needed as an incentive beyond a point, if at all. Accordingly, some of the benefit due to the low interest rate policy is a subsidy for homebuyers.

A similar argument applies, mutatis mutandis, in the main case of companies that are borrowing for real investment. Also, given the low interest rates, the stock market is booming, though there are other reasons as well. This is not a case of real investment; it is financial investment. The element of subsidy in the low interest rate here is substantial, if not complete. Also, the government is a beneficiary of the low interest rate policy as it is a big borrower. It may be awkward to say that the government receives a subsidy. However, this does not change the economics of it all.

Just how big is the subsidy in all this? Carveth Read (1848–1931), the British logician had observed, “It is better to be vaguely right than exactly wrong”. So, I will provide an estimate here, even if it is rough.

Over the last three years or so, the Reserve Bank of India (RBI) has lowered the repo rate by about 2.25 percentage points. It is true that the transmission of the RBI policy can be weak, in which case the interest rate for borrowers would have fallen a little less. Also, though the low interest rate applies immediately to the new flows, it applies gradually to the existing stock as there is a roll-over of funds. Let us say that the interest rate fell by only 0.5 percentage points for the entire stock of debt. Even this is significant. But the story does not end here.

Over the last three years, the average rate of inflation has been about 5.4 per cent; it was previously at about 4 per cent. So, we have about 1.4 percentage point rise in the average inflation rate over the last three years or so. Given the 0.5 percentage point reduction in the nominal interest rate, which we considered above, and the 1.4 percentage point rise in the inflation rate, we get a 1.9 percentage point reduction in the real interest rate.

For lack of a better method/assumption, let us assume that half of the 1.9 percentage point reduction in the real interest rate is an incentive and the remaining half is a subsidy. We then get a 0.95 percentage point reduction in the real interest rate, which is a subsidy.

Since we have considered the various forms of lending or investing in debt securities, we may consider the aggregate figure for savings that are invested in debt instruments. These include deposits in banks, units in debt mutual funds, debt instruments issued by non-bank finance companies, etc. For a complete figure, we also need to include indirect investments in debt instruments through “intermediaries” like insurance companies, in hybrid mutual fund schemes, etc. Let us simplify and consider only bank deposits, and units in debt mutual funds. These stand at Rs 164.51 trillion (as of August 27, 2021) and at Rs 14.91 trillion (in November 2021) respectively. Ignoring the slightly different dates, the total is Rs 179.42 trillion. Recall that we have a 0.95 percentage point reduction in the real interest rate, which is a subsidy. So, this amounts to a whopping Rs 1.71 trillion a year.

Let us put the number of Rs 1.71 trillion in context. The much enhanced expenditure under the Mahatma Gandhi National Rural Employment Guarantee Act last year was Rs 1.11 trillion. So, the subsidy in the interest cost is huge indeed.

The subsidy here is not paid by (affluent) taxpayers. Its burden is on the less well-off and the less well-informed people who get much lower interest income. This is a case of an undesirable redistribution.

The writer is visiting faculty at the Indian Statistical Institute, Delhi Centre