This simple method of calculating ex-post real interest rates depends on reported rates of actual inflation. However, this approach is perhaps too simplistic. Instead of taking the ex-post rate, the calculation of real interest rates should be based on ex-ante or expected rate of inflation. The expected rate lies in peoples' minds depending on their view of the economy's future. Inflation may be down but it is still on the peoples' mind. In order to really lower inflationary expectations, people have to have confidence that the low rates of inflation will be maintained.

Bringing down inflationary expectations leads to lower real interest rates, a point which was earlier used by the Reserve Bank of India (RBI) to target inflation rather than interest rates. Another way of stating the same is that if inflationary expectations are not brought down, nominal interest rates tend to be downward rigid, they do not move downwards in sync with inflation rates. Why does that happen? Due to the fact that expected inflation stays high though actual inflation has come down.

Since deducting the weekly WPI from the prime rate is not the most satisfactory way of calculating real rates, what then would be a better method of doing this? This depends on what the real rate is used for. A borrower pays a contracted rate for his borrowing which is the nominal rate. This implicitly includes the real cost of capital and the expected rate of inflation. The second part he fully expects to pass on in terms of price increases or in other words it cancels out from his cost and revenue streams.

This has not happened in the last three years. From the industrialist's point of view the rate of inflation for manufactured goods, which forms the bulk of the weightage for the WPI, is the most relevant. Prices of manufactured goods rose at an average of 9.1 per cent between 1993 and 1996 and then fell to an average of 4.2 per cent in 1996-99. In the same periods the average prime lending rate declined from an average 16.8 per cent to 13.8 per cent. So the decline in inflation in manufactured goods has been much more than the decline in the prime lending rate. Thus real interest rates rose by 200 basis points. This is the increased burden that Indian industry has had to bear.

Over a three year period one would expect the nominal rates to adjust downwards but this has not happened because inflationary expectations have stayed high. The reasons are not hard to find. The last three years have seen a steady rise in the deficits of the central and state governments. If the biggest borrower in the market is set to borrow more why should interest rates come down? The high rates on the government small savings scheme is a reflection of this and prevents deposit rates from moving down. Though small savings rates have been lowered it has not gone far enough.

There is no inflation band that the country targets and there is no legal compulsion for fiscal responsibility, which binds all parties, leading to inflation volatility and a ever increasing deficit. Inflation for manufactured goods, though relatively more stable than primary articles, has varied between 11.3 per cent (1991-92) and four per cent (1996-97). Liquidity has been managed with various short term targets in mind. At times, it has been used to crash the inflation rate in a hurry, at times to hold the exchange rate and at times to target nominal interest rates in view of government borrowing.

It is very difficult to bring down inflationary expectations without setting longer term inflation targets and effective methods of control. Credibility in fighting inflation has to be earned before people start expecting sustainability in lower interest rates.

Where does this leave the Indian entrepreneur? With the decline in import duties and a World Trade Organisation (WTO) world looming in the near future Indian industry is having to bear the burden of high real interest rates, nearly five-six per cent higher than the developed countries. Combined with higher labor market rigidities and higher energy costs, global competitiveness seems out of reach for most industries.

Currently inflation is the good news but inflationary expectations is still bad news. When interest rates refuse to come down, what the lender is saying is, that he would rather look at the future fiscal deficit and the importance given to targeting inflation rather than the present bumper crop.

The author is a director with Anand Rathi Securities