Headed For A Low Interest Rate Trap

Updated: Feb 25 2002, 05:30am hrs
Recently, a great deal of concern has been expressed by academics and market participants regarding the level and sustainability of the current level of interest rates. While some argue that, given the relatively high level of fiscal deficits and expected growth in corporate demand for credit, the current low level of interest rates cannot be sustained, others argue that the low level of inflation implies a high level of real interest rates that needs to be further brought down to facilitate corporate revival and lower the burden on primary deficits.

The market seems to believe that the government and RBI have an objective and the ability to implement policies to maintain low interest rates. The government and the RBI on their part have undertaken a series of measures such as reduction in small savings rates, bank rate etc.

The rationale provided for such a concerted policy action to bring down interest rates is that it will facilitate the revival of industrial growth, align domestic real interest rates with global interest rates and reduce the burden on the fiscal deficit via reducing the cost of the borrowing for the government. As our experience has shown in the last one year, in otherwise difficult times, the linkage between interest rates and growth is at best weak. The notion that real interest rates are too high in India stems from the mistake of using the current level of inflation as a proxy for expected inflation used to calculate real interest rates. It is almost certain that, with high fiscal deficits and dismantling of APM, the average annual inflation rate will be above 4 per cent over the medium term. The real interest rates at this horizon would, therefore, be about three per cent, marginally above the global rates.

Again, the low cost borrowing option seems to have led to a significant increase in government borrowing, thereby nullifying the benefits of such a policy. Herein lies the first cause for getting into a low-level interest rate trap: low interest rates are needed to finance fiscal deficits at low cost; low cost debt financing option will increase market borrowing; and to finance higher levels of debt interest rates need to be kept further low.

The second compulsion for lower interest rates comes from concerns about the the banking system: it today holds almost 60-65 per cent of the total outstanding government debt. This portfolio has an open position of Rs 3.5 trillion and duration of 5.1 on a mark-to-market basis, implying that an increase in interest rates by 100 bps would lead to a fall in the portfolio value to the tune of Rs 16,000 crore. The losses in market value by such a magnitude could lead to a crisis. In the absence of any other policy that could internalise the losses of the banking system, the government could be forced to undertake policies that sustain a downward pressure on interest rates. It should be noted, however, that the costs of maintaining interest rates at artificially low levels will increase over time as the corporate demand for bank credit picks up and the economy starts moving out of recession.

Are there alternatives by which the government could avoid falling into the interest rate trap In my view, there are three policy options. In the immediate short run, assuming that fiscal correction is an impossibility, the government could consider monetizing the deficit. This will increase the inflationary pressure on the system, a luxury we can afford in the current context of low inflation. on The other hand, it will prevent the government debt from ballooning into unmanageable proportions. The second policy option is to actively encourage banks to move into alternative investment avenues (such as equity) and hedge their risks via appropriate instruments such as interest rate derivatives. Finally, corrective action to control fiscal deficits is the only sustainable solution to the problems discussed above.

(The author is a consultant with the NSE. The views expressed here are the his own and do not reflect those of NSE)