Where should India's real interest rate be relative to the world?
The Governor of the Reserve Bank of India has made a curious, possibly fallacious remark. As reported in Business Standard on 30 July 2008, Dr Y V Reddy said to his interlocutor in Hindi “Look friend, you go to the marketplace and you know that the price of rice has gone up, the price of cooking oil has gone up, the price of dal has gone up, so should not the price of money also go up? Balance has to be kept, that is what we are aiming at.”
Why the remark may be fallacious is not hard to see. Imagine the world contained only the three things Dr Reddy mentioned plus, of course, labour, making a total of four goods and services. Suppose their prices per unit expressed in money were Rs 30, Rs 40, Rs 20, Rs 60 respectively, and those rose instantly and uniformly to Rs 60, Rs 80, Rs 40, Rs 120 respectively. Inflation would be measured as 100 per cent though people’s real consumption, production and exchange decisions would be unaffected since the three ratios between the four goods and services had not changed.
But inflation is decline in the real value of money just as much as it is a uniform rise in the money prices of goods and services. For money prices of goods and services to rise by a given percent is the same as the real price of money falling by that percent. One unit of money could purchase 1/30, 1/40, 1/20 or 1/60 units of the four goods and services — after 100 per cent inflation, it will purchase only 1/60, 1/80, 1/40 or 1/120 units respectively.
Dr Reddy may have meant to say that he wants to see the real value of money rising in order to cause money prices of goods and services to stop rising. His Hindi remark was followed in English: “…when the prices of commodities increase and if you are uncomfortable with the prices, you wish that why not the price of money increases. So that is the balance we are targeting. If you want the prices of commodities to stay at comfortable levels, you may have to compromise with slightly higher interest rates”.
This too is obscure to the point of being confusing. Borrowing and lending and the interest-rates that match them together in credit markets ultimately have nothing to do with the institution of money as such. A rural household may lend another 10 kg or 100 kg of grain or seed for a short time; it will expect to receive back a little more than the amount lent even if that little amount is in services or goodwill among neighbours. That extra amount is “real interest”, and the percentage of its value relative to the whole is the “real rate of interest”. If 10 kg of grain are lent and 11 kg returned, a real rate of interest of 10 per cent has been paid over the period. The future is always less valuable than the present in the sense 10 kg of grain today is worth something more than the prospect of the same 10 kg of grain tomorrow.
Because most loans in a complex economy are in monetary terms, the change in the value of money over the period of the loan becomes relevant. If a bank lends money for one year at 13 per cent when the real value of money declines at 11 per cent over the year, the borrower pays real interest of 2 per cent. The American economist Irving Fisher described this monetary rate of interest equalling the real rate of interest plus the rate of monetary inflation, while the Swedish economist Knut Wicksell predicted inflation if the monetary rate fell below the real rate, and vice versa.
Capital, both machinery and finance, being relatively scarce as a factor of production (compared to labour) means rates of return and profit are very high in India. Irving Fisher’s own data of 1864-1926 showed Indian interest rates secularly above world rates.
But financial sector repression in recent decades until 1991 at least caused formal sector rates to have been so artificially lowered as to be lower in capital-scarce India than in the capital-rich West!
The best interpretation of the Governor’s remarks is that he thinks India’s monetary rate of interest needs to rise towards the rate of return on capital in order for inflation to be arrested. This may well be true in part but in the Indian case even this is far from enough by way of analysis. Our credit markets remain drastically segmented into a formal organised sector and a vast informal unorganised sector. Government policy may want to allocate bank-credit equitably but if debtors cannot be distinguished, credit terms tend to subsidise bad risks and tax good risks. A creditor who knows each debtor individually will also know their credit-risks, and price loans accordingly which is what the proverbial wicked village money-lender does. Everyone hungers after subsidised formal sector bank loans, which get rationed quickly and often allocated to people known to bank officials (like their own friends and relatives). Negative or near-zero real interest rates in our formal financial sector coexisting with massively high profit rates in informal credit markets point to continuous processes of low-risk profits being made by arbitrage between the two. That may be why the organised sectors never seem overly bothered with policy-changes while every borrower in the informal credit markets has suicide not far from his/her mind. Dr Reddy may raise the repo rate a few basis points to make money slightly less cheap in the formal sector but that will hardly reduce segmentation or interest rates at 1 per cent, 2 per cent or 5 per cent per day in informal credit markets.
