Wilful blindness and interest rates

India’s 10-year government bond yield, the benchmark for interest rates, is now pushing 8 per cent after the Monetary Policy Committee (MPC) raised the repo rate by 25 basis points. This would be a shock for those who had been dreaming of a Ram Rajya of low interest rates, following the “reforms” done by the present government. A low interest rate, it was hoped, would lift asset prices and unleash economic growth that would go on for decades and turn India into a prosperous nation. Many financial analysts genuinely believed that interest rates were on a path of secular decline in India. The respected website tradingeconomics.com predicts the interest rate will go back to 6.25 per cent in 12 months and, in the long term, it says, India’s interest rate “is projected to trend around 4.75 per cent in 2020, according to our econometric models”. Is the steady rise in bond yields over the past year temporary? Are we still on the path of low interest rates over the long term?

The view that India’s interest rates are on a long-term decline is a combination of three kinds of wilful blindness. One, extrapolation and recency effect — interest rates will go down because they have been down all through 2014-16. This kind of blindness leads one to ignore why they had gone down and how little it would take for those conditions to reverse. Two, deep faith in the current government’s desire and ability make structural changes, and being blind to the fact that it is as socialist (and therefore statist), if not more, as the previous governments. Three, delusion about India’s macroeconomic strength and its ability to attract portfolio and investment capital, which are additional strong determinants of the supply of money, and consequently interest rates.

India’s 10-year government bond yields had crossed 9 per cent in the currency crisis days of late 2013 and early 2014. Even after the euphoria of the Modi government coming to power, the 10-year yields were still around 8.6 per cent. Then in June came the epic collapse in crude oil price, which fell over 70 per cent from June 2014 to February 2016. This, and a few other factors, caused inflation expectations to go down, and allowed the Reserve Bank of India (RBI) to steadily cut the repo rate from 8 per cent in 2015 to 6 per cent in 2017.

Falling interest rates were a clue for players in the financial market, whose job requires them to be very positive and flexible by temperament. They kept up a steady drumbeat of propaganda that interest rates would continue to fall. Presentations of wealth managers and distributors, I hear, projected that interest rates to go down to 4 per cent over the long term. This was never seen even during severe economic contraction of the past. This propaganda, combined with a cut in bank deposit rates, made many of India’s overwhelming majority of conservative savers anxious about their horde of fixed-income investments. 

Then came this government’s showpiece of economic policy — the note ban or demonetisation. It contracted economic activity (thereby reducing demand for money) and pushed the money into banks, bumping up supply. The 10-year bond yield collapsed to 6.24 per cent. That was a trigger for many panicky and conservative savers to move their money in droves into risky products like equity funds and stocks. The Sensex rose 40 per cent from the lows of December 2016 to the highs of January 2018, even as corporate results showed patchy growth.

After flirting with 6.5 per cent, the 10-year government bond yield rose steadily, as the Central government marched ahead with bank recapitalisation and redistributive schemes and state governments announced loan waivers. Against this backdrop, policymakers, businessmen and politicians were irked that the RBI was not cutting rates! In December 2017, Ashima Goyal, a member of the Prime Minister’s Economic Advisory Council, made the extraordinary comment that the RBI believes “inflation will rise, but you know their predictions of inflation have always been overestimated …Their view of the economy doesn’t seem to be correct,” she said, adding that by keeping rates high, they “have imposed a high output sacrifice”. Well, just six months later the MPC was forced to hike the rate, instead of cutting it! Who is overestimating what, is clear now.

India is a capital-scarce country. The interest rate can go down in a healthy manner only if there is a virtuous cycle of improvement in productivity, higher savings, higher inflows and so on, which generate and attract capital. This cannot happen on its own. It would need the government to take two crucial steps. One, stop killing the productivity of enterprises with myriad local laws and regulations, which merely lead to extortion and coercion. Two, stop borrowing money from the scarce pool of capital, to waste it on hundreds of schemes, projects, salaries and interest cost. Both these are pipedreams. The fact is, over the past 20 years, interest rates have gone down sharply only due to short-term factors, usually fortuitous (big decline in oil prices) or unhealthy (note ban or economic slowdown of early 2000 and in 2008). The reality of India’s unchanging political economy (and, as a consequence, big government) will not let interest rates go down much. 

The writer is the editor of www.moneylife.in

Twitter: @Moneylifers