The PM’s economic advisors spelt apocalypse

Will Pundit Reddy be the saviour of small savers?

SS Tarapore

Following the advice of the prime minister’s Economic Advisory Council (EAC), the finance minister announced, in the union budget, a large cut in interest rates on small savings and provident funds. The EAC’s predilection was for low interest rates to sustain a higher real rate of growth. The EAC went on to pronounce that interest rates on small savings and provident funds should be reset half yearly at no more than 2 percentage points above the inflation rate of the previous six months.

I have repeatedly argued (FE Feb 28 and Mar 14) that the logic of the wise men of the EAC is flawed as they have used sham methodology to reach loopy conclusions and made a hash of interest-rate policy. While the finance minister has already slashed interest rates on savings instruments he has set up another committee of wise men to advise on the calibration formula. The members of the Reddy Committee have impeccable credentials and one can be sure that they will come up with a viable and equitable system to balance the government’s passion to borrow at lower and lower interest rates and the savers’ legitimate demand for fair compensation.

Interest rates have been high not because of the avarice of small savers but because investment demands are higher than the available savings. The household sector, the backbone of the locomotive of growth, has little collective bargaining power and is completely crushed by the combined brute force of industry and government.

The Reddy committee has to detach itself from these forces and ask what kind of interest rate setting will ensure an adequate flow of savings. There is an insensate articulation that savers take no risks and should not be recompensed with high interest rates while government, which has social obligation, and industry, which takes risks, should be rewarded. The Reddy committee should put paid to such stultifying nonsense.

True, nominal interest rates cannot be unrelated to inflation rates. In calibrating interest rates on small savings the committee should not hesitate to adapt the formula suggested by Dr Reddy a couple of years ago wherein nominal interest rates could be based on a five-year moving average inflation rate with a distributed lag, where the weights could be highest for the immediate previous year and lowest for the year furthest away from the year under reference.

Now, if the year under consideration is say t, the weights could, illustratively, be 5 for year t-1, 4 for year t-2, 3 for year t-3 2 for year t-4 and 1 for year t-5. The inflation rate derived from such a calculation would take greater cognisance of the more immediate period and a lower weightage for a more distant period. Recall the analytical dictum that the long-term rate of interest should be the average of the future anticipated short-term interest rates adjusted for risk and uncertainty.

For a moment let us concede the EAC’s pronouncement that the real rate of interest for savers should be 2 per cent. If the inflation rate in year t-1 is high then according to the EAC formulation the interest rate in year t would be high and if the inflation rate in year t-1 is low then the saver will face a sharp drop in the interest rate.
The Reddy committee should toss out the EAC recommendation and adopt the Reddy formula which will ensure that the interest rate on small savings will not move sharply from year to year. The attraction of the small savings schemes has been predictability of interest rates. If volatility is introduced the government could just as well invite savers to the Casino — and we all now know what happens there!

On the choice of the inflation rate, the committee would do well to use the headline inflation rather than core inflation. The further choice would be between the point-to-point rate and the average rate; there are advantages for either formulation but once a choice is made credibility warrants that the authorities should not oscillate. Again, between the wholesale price index (WPI) and the consumer price index (CPI) it would be preferable to use the WPI. The calibration should be once a year rather than half yearly. While the EAC does not openly advocate indexed bonds, implicit in their recommendation is an indexed bond. Savers must be given a cafeteria choice of a fixed nominal rate of return as also an indexed bond. Moving all instruments to an indexed rate may not be that good an idea for savers or government.

On the transfer of funds to states, the present 85 per cent of the proceeds could be raised to 100 per cent. With this three issues need to be resolved. First, there should be a total match between the maturity of resources raised under small savings and the repayment by the states. Second, the incidental costs of raising these resources should be borne by states. Third, the burden of the tax incentive regime has to be worked out. Since the bulk of income tax receipts are transferred to states there need be no change in the present system but there remains the problem that the state-wise incidence of income tax incentives may not match the state-wise allocation of small savings.

The committee must distance itself from the great passion for reducing interest rates; it should take a neutral stance between the desire of government and industry for lower interest rates and savers’ aspiration for reasonable returns. The committee should concentrate on evolving a viable structure of interest rates consistent with longer-term growth. It must be recognised that artificially low interest rates are detrimental to real growth. A characteristic of the Indian financial system is the uni-directional movements which continue till there is a jolt, resulting in a 180-degree turn in the other direction. Such excesses, in both directions, cannot but damage the economy.

Small savers have been left with a feel-bad factor bordering on apocalypse, with the EAC spraying misery on them. Pundit Reddy and his team have their work cut out. If they realise that the future of the economy lies in their hands they would no doubt find it awesome.