The interest question

The Prime Minister's economic advisory council is reported to be of the view that nominal interest rates may have dropped too low as the system responded to the low rates of inflation that prevailed in 2001-04.

The council is said to be worried about the effect the low rates will have on savings, especially since banks now offer deposit rates that are lower than the rate of inflation.

So the argument has been joined: has the time come to raise interest rates? The international climate would suggest: yes, since US rates have started going up and further hikes have been signalled.

Also, with the incremental credit-deposit ratio for the banking system ruling at around 90 per cent and more, it is only a matter of time that Indian rates also go up.

This has been known for some time and the markets have been adjusting. By how much more they should go up depends on the view taken on the real interest rate, i.e. the nominal rate minus the inflation rate.

The chairman of the council, C Rangarajan, believes that during periods of rapid GDP growth (as in India now), the real interest rate has to be higher than it is in the developed countries, and said as much in his Kale Memorial Lecture a year ago.

Also, he says, a situation where the real rate is high because of high growth is different from one where it is the result of market imperfections.

It is very important that "the real interest rate be kept at a level necessary to generate the savings and investment needed to support rapid economic growth".

Not everyone would agree with this, and many would argue that India managed to generate economic momentum in the last couple of years because of bank-funded retail demand that was the result of lower rates; higher real rates now will choke off the nascent investment boom.

That is probably true, but looking forward there are two elements to be kept in mind""the likely rate of inflation in 2005 and the impact of interest rates on savings.

The rate of inflation has been dropping steadily, so barring external shocks inflation can be expected to be around the 5 per cent mark. That does not suggest the need for corrective action.

As for savings behaviour, when interest rates are low people actually have to save more in order to get the same income from savings.

But research by Norman Loyza, in a paper for the World Bank, has shown that the higher the interest rate, the more Indians save. So there is ammunition available for both sides of the argument.

The Reserve Bank, it seems, would prefer to come down on the side of low interest rates.

Its annual Report on Currency and Finance points out that "a 100 basis point rise in real interest rates depresses real GDP and widens the output gap by five basis points in the short run.

The impact increases over time and the long run impact is almost 40 basis points." In other words, if you raise interest rates, you will slow down growth.

And given that the problem in India today is not low savings but low investment, the angels might argue for continuing with a low interest rate regime.