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How Low can our interest rates go?

An economic slowdown in the country and successive repo rate cuts by the Reserve Bank of India (RBI) has made the headlines recently; as also the fact that this particular move has not yet been successful in boosting consumption demand. The GDP growth rate of the economy has fallen to 5% in the first quarter of FY20, the lowest in six years. This growth recession has been attributed to the recent collapse in the automobile industry, sluggish consumer demand, an increasing number of non-performing assets and failing manufacturing sector. And this decelerating growth had clearly been anticipated by the authorities as well, which is why there have been 4 interest rate cuts since February this year.

In its most recent meeting, the RBI’s Monetary Policy Committee (MPC) unanimously agreed to cut repo rates for the fourth time this year, which currently stands at 5.40%. For laymen, the repo rate is the rate at which commercial banks borrow money from the central bank for their short-term requirements. Reducing the repo rate will induce commercial banks to reduce their lending rates, and individual economic agents will have cheaper access to credit. A key expansionary monetary policy technique, the central bank reduces repo rates when the economy is going through a sluggish demand phase, and there is a need to revive the same in order to maintain economic growth.

The reduction in repo rates is the RBI’s response to the growth recession, but it has been mostly unsuccessful in reviving demand. So what can the RBI do further: should it further reduce rates, or should it try another approach to solve the problem?

When it comes to further reduce rates, it is to be remembered that negative interest rates (which have been introduced in certain European countries) will not be sustainable in a developing country like India. Not only would commercial banks be reluctant to lend, but people would also prefer to put their savings “under the pillow” than investing them in ventures offering negative interest rates. So how much more can the rates actually fall? The answer to that question can be given using Taylor’s Rule.

Taylor’s Rule is an interest rate forecasting model invented by economist John Taylor in 1992, which suggests how central banks can change interest rates, given a certain neutral interest rate and a potential level of output. It is given by the formula

I = R* + PI + 0.5 (PI – PI*) + 0.5 (Y – Y*)

I = nominal interest rate, R* = real interest rate, PI = rate of inflation, PI* = target inflation rate, Y= logarithm of real output, Y* = logarithm of potential output

In an article in the LiveMint by Niranjan Rajadhyaksha, the author calculated a level of interest rate to which the repo rate can fall. He assumed that Indian economic growth is one percentage point below potential, inflation is half a percentage point below its target and the neutral interest rate is 1.25%. This would peg the repo rate at 4%, which still gives the RBI certain scope of further reduction in rates.

All of this calculation looks good in theory but is very difficult to implement in reality. Monetary policy is much more complicated; moreover, the fact that falling rates till now have had no impact on demand is concerning. The inflation rate was 3.21% year-on-year in August 2019, much below the RBI’s medium-run target of 4% for the 13th consecutive month. These figures are alarming, particularly when comparing them to an average inflation rate of 6.02% from 2012 to 2019.

The falling repo rate has had no impact on lending rates of commercial banks. In fact, the weighted average lending rate of banks has gone up from 10.38% to 10.41% since January this year, which shows that despite the expansionary monetary policy, bank lending rates have not fallen; on the contrary, they have risen.

One reason to attribute to this paradoxical case is related to credit deposit ratios of commercial banks. The credit deposit ratio (CD ratio) is obtained by the total number of loans given out divided by the total deposits of the bank. As of July 2019, the CD ratio is 76.3%, i.e., out of every 100 rupees a bank gets as deposit, it gives 76.30 rupees as loan. The total reserve requirements in the same period are 23.5% of total deposits ( CRR at 4% and SLR at 19.5%). This implies that banks are lending out all of the money they have available after meeting their reserve requirements, they cannot lend any more than they already are, unless there is a reduction in CRR and/or SLR. This is not a safe option for the RBI, considering the prevalent NPA crisis and the precarious position the banking sector is in right now.

Falling household savings are another reason why bank deposit growth is lagging and banks cannot reduce their rates. Overall savings have dropped to 30% from 34.6% in the last five years, household savings to 16.3% from 23.6%. A question that naturally comes to mind now is, how is it that savings are falling and so is demand? Why are people not saving, and not buying goods, or investing in property? The answer to this question might be that people are spending more on services that eventually do not translate to consumption demand. This includes education, sanitation needs, and medical expenses; and this is where we find an answer to sluggish demand as well.

India has tremendous income disparity; the top 1% own 73% of the wealth in the country. Together with income inequality, we have the issues of sub-standard government education and medical services, and exorbitantly priced private substitutes of the same. Middle and lower-middle-class people aspiring to improve their living conditions invest more in educating their children and consequently reduce their spending on other goods. This is what has led to the lapse in demand.

In these circumstances, more than monetary policy reforms, the country needs fiscal policy reforms, in the sense that the government should increase its spending on education and healthcare, making sure that they obtain nearly, if not completely, private standards. If people spend less on services, they will spend more on buying consumer durables, investing in property and of course, savings will increase.

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2 Comments

  1. Suneel

    I don’t find mention of weak monsoons this year that has aggravated the situation. Property and high priced education are urban phenomena. How about declining rural demand? Would like to see more holistic analysis.

    All the best.

    • Ranjana Sinha

      Point noted. The article was focused more on the issue of falling interest rates and credit policies, specifically on a mathematical estimation of the interest rate, and the last paragraph briefly mentions some of the reasons that can be held responsible for falling investment. This was a more from a financial perspective than an economic one, had it been the latter I would have included the points you mentioned.

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