Right from Independence, we have had relatively high interest rates in the economy. Inflation has been quite high and capital in short supply. Both these had contributed to high interest rates. However, in the last three years, there has been a significant change in the scenario. Inflation has fallen to historic lows, though recently prices had hardened largely due to the Iraq war, and to a lesser extent, due to the drought situation last summer. With inflation being low, the monetary authorities could afford to loosen the purse strings of the bankers. Successive reductions in the cash reserve system have put more money into the economy. Further, opening up of investment regulations - both direct and portfolio - has led to larger capital flows. Interest rates today are a good five per cent or so lower than what they were three years ago.
But the party may be stopping soon, much before all of us had imagined. A small but vociferous section is trying hard to keep interest rates artificially high and thereby thwarting the well-crafted plans of the finance ministry and the Reserve Bank. On the 31st of May, the trustees of the Employee Provident Fund will meet to decide whether they would bring down the interest rate from the existing 9.5 per cent to eight per cent, which the government is shooting for.
The interest rate scenario in the country is best typified by the yield on 10-year government paper, which even as I write is around 5.75 per cent. This is taxable. In other words, the government is able to borrow thousands of crores of 10 years duration at less than six per cent. As against this, the provident funds are paying 9.5 per cent to the contributors. Considering that this is also tax-free, the pre-tax return comes to around 13 per cent. So we have an absolutely unparalleled situation where the government is on the one hand able to access money at six per cent, but is paying at more than double the rate.
Economists and financial analysts are aghast at this contradiction and are fervently hoping that this situation is set right. There is a perception among some that giving this type of high return is a welfare measure. This is no doubt true on the face of it, but a deeper analysis would show that the repercussions of this would far outweigh the possible benefits that a few persons may garner.
The first big adverse impact will be on government finances. If the provident funds pay 9.5 per cent but get only six per cent on their investments - and they can invest only in government-backed instruments for reasons of safety - there is going to be a massive difference of 3.5 per cent, which will have to be plugged. This hole may be a very deep one indeed, and would have a terrible impact on the fiscal deficit. It will make a mockery of the fiscal responsibility legislation that is about to go into the statute books.
While economists will sweat about the impact on the fiscal deficit, businessmen are worried of their global competitiveness. As they rub shoulders with the Chinese and the Far-Eastern tigers to capture markets, the biggest handicap they face is the high cost of capital. Study after study has shown that this disadvantage translates into a margin difference of around five per cent for Indian exporters. So, when we keep interest rates high, our cost of production goes up making us globally uncompetitive. This is not the only problem for exporters. Already the high interest rates in India have attracted global hot money. The rupee has strengthened beyond all expectations due to this phenomenon, and when the rupee gains not due to intrinsic competitiveness but high interest rates, the exporter gets priced out.
Well, you may say - let the economists and the businessmen sweat; we are keeping the work force happy. But are we If the fiscal deficit goes up, government has less money to spend on infrastructure and this immediately leads to less job opportunities. But for the high interest payout, government could use the money in the social sector for rural development, agriculture, health and education. If exports face the pressure, production immediately suffers, leading to loss of jobs. These linkages between interest rates, investment and employment are well-known and well-accepted. This is why most politicians, even if they have their own populist agendas, work very hard to encourage investments by keeping the cost of capital low. We should use the same strategy, which has worked elsewhere. If all interest rates in the country are brought down, the signal will go out that India is indeed a low-cost economy. This will encourage capital to move in, thereby giving a much-needed boost to growth.
When the provident fund trustees meet on the 31st of May, it would be good for them to realise that what is at stake is not the rate of interest, but the future of the entire economy. If they thought beyond the immediate and followed the path chosen by the finance ministry as shown in the reduction in small savings interest rates, the impact on the economy will be electric.
The author is a Delhi-based investment banker and Convenor of the BJP Central Economic Cell. The views expressed herein are personal. He can be contacted at email@example.com