A floor on rates

Given the behaviour of interest rates monetary stimulus has limitations

The rate of interest paid on small savings has been reduced over the last couple of years from a peak level of 12 per cent. In early 2000, it was brought down to 11 per cent. In the Union Budget for 2001-02, it was further reduced to 9.5 per cent and in this year's Budget, it was taken down a notch to 9 per cent. The reduction in this rate is a major bone of contention.

On the one hand, people argue that this rate acts as an effective floor on all rates. When it is pegged at an artificially high level, it forces other interest rates in the economy to conform to that level. Private investment is therefore crowded out. On the other hand, there is a perception that this rate needs to be kept high to induce savings. A combination of high interest rates and tax benefits, which have also been abolished in this year's budget, made small savings instruments the predominant pension plan for large numbers of people. Lower rates are seen as changing the economics of retirement for them.

The "breach of trust" that the government is accused of for the substantial reduction in the rate can be countered by arguing that the rate must accommodate the significant reduction in the rate of inflation that the economy is currently experiencing. If, in the foreseeable future, the average rate of inflation is going to be, say, three percentage points below that of the last couple of decades, people who bought into these instruments at 12 per cent will be no worse off if the rate now declines to 9 per cent. The purchasing power of the interest on their savings will remain the same. The eventual indexing of the interest rate to market rates will accommodate changes in inflationary expectations, which will show up in the market rates. So, while people are understandably upset with having to settle for lower rates on their savings, in the practical sense of the purchasing power of their income streams, they are, in all likelihood, no worse off.

Does the "floor" effect of artificially high rates on small savings clinch the argument then? Is the steady lowering of the rate and its eventual alignment with the market for debt instruments going to fundamentally change the mechanics of interest rate determination in the economy? The accompanying figure displays the movements over the last five years (April 1996 to September 2001) of three different rates: the yield-to-maturity on 91-day treasury bills, reflecting the short end of the spectrum of debt instruments; the yield-to-maturity on 10-year government securities, representing the long end (although the government issues securities of far longer duration now); and, the small savings rate.

The dominant impression I get from the pattern is that the small savings rate has acted as a floor on the long-term rate. In the first half of the five-year period, the movement in the short-term rate reflects a significant easing of liquidity conditions in the economy. The long-term rate also responds to this stimulus, and even falls below the small savings rate for a short period, but then quickly climbs back up above it, even as the short-term rate continues to show the effects of liquidity.

Once the long-term rate finds the small savings rate, it clings to it with apparent insensitivity to what is happening at the short end of the market, which now shows signs of tightening liquidity. It is only when the small savings rate is brought down for the first time that the long-term rate follows suit. A spurt in the short-term rate towards the end of the period also causes a spike in the long-term rate; at this point, the short and long rates appear to be moving in far greater consonance, as the floor represented by the small savings rate is lowered. I did not extend the series forward for lack of comparable data, but recent movements in long-term rates indicate a significant decline.

The close tracking between the small savings rate and the long-term rate can be fairly easily explained. After all, both represent returns on government borrowing from alternative channels.

If one is pegged, arbitrage will ensure that the other converges to the pegged level. That arbitrage is being done by the banking system, which is competing for deposits from people who would put their money in small savings. As the flow of funds to small savings declines because of the rate reduction, this money goes into bank deposits. The banks, in turn, who are currently investing significant amounts in government securities, bid up the prices of these securities and thus drive the yields down. In recent times, debt-dominated mutual funds are also arbitraging between the two channels. The point is that small savings instruments are close substitutes for longer-term bank deposits (and similar instruments), so arbitrage will always ensure a convergence of rates.

Clearly, however, the short-term rate is driven by a different set of factors, primarily liquidity, and this is where the policy issues come in. The graph shows that even when the short-term rate declined significantly, the long-term rate did not respond. However, when the former increased, the latter responded. This reflects the classic monetary policy dilemma: you can pull on a string but not push on it. Tightening liquidity affects the entire spectrum of interest rates, but loosening it takes the long-term rate down to the floor. The room for monetary stimulus in the face of this artificial floor is obviously, then, rather limited. The short-term rate will react immediately, but the long-term rate, which is presumably the one against which returns on investment in new projects are benchmarked, merely hits the floor. The higher the floor is, the fewer the projects that can be justified.

From this perspective, the progressive reduction and market orientation of the small savings rate actually increase the prospects that a monetary stimulus will work. As I said earlier, the recent behaviour of long-term rates has seen them falling below the "floor". This could be a temporary aberration as banks invest disproportionately in government securities. If past patterns are any guide, one would expect a reversion to the new lower floor. A few more investment projects will presumably turn out to be worthwhile. The overall investment climate, of course, is rather hostile and it is too much to expect the lower rates to offset all the other disadvantages, but every little bit helps.

Finally, to get back to the savings controversy, the emergence of private insurance providers which are offering a variety of pension plans, should fairly quickly ease the apprehensions of people who saw no alternative to small savings for their nest eggs. Even if they end up putting most of their money in government securities, they will do it far more efficiently than the public sector banks, in particular. What the saver loses in interest rates will be more than offset by savings in intermediation costs.