212059 SIP myths you must know!

Recently there was a notification which was issued — and promptly withdrawn. The notification pertained to reduction in the rate of interests on small savings deposits. The withdrawal did not come as a surprise given the political difficulty in reducing small savings rates in India.

However, this reduction is inevitable. That is, as much as people try to resist the move to a low interest rate regime, it is bound to happen, as it has occurred across the world. It is important to understand how interest rates are determined and how it impacts the economy.

The repo rate determined by the Monetary Policy Committee plays a major role in determining interest rates, both on deposits and loans. The transmission of repo rate changes to rates across a variety of products was relatively weak which is why RBI has over the months made an attempt to get banks to link a variety of their products with the repo rates.

It is worth noting that repo rate at present is at 4% — an outcome of a series of rate cuts announced during COVID-19 pandemic. The low repo rate was made possible due to the reduction in the inflation rate in India. Many people have often ignored that India witnessed a transition from a moderate inflation economy to a low inflation economy (a 4% inflation rate for an EM can be considered as frictional).

This transition started from mid-2013 onwards – long before adoption of inflation targeting and formation of the Monetary Policy Committee. A fact that has been recorded recently in a series of presentations by Surjit S Bhalla based on our research on the subject. This moderation in inflation rates was slow to be reflected in the moderation in repo rates. But with COVID–19, a lot of the rate cuts got accelerated, thereby bringing us at 4%.

It is therefore important to ask that at a time when home mortgages are at close to 6.5-7% and credit to industry is being provided at 9%, is it feasible to provide a 7.1% interest on PPF? More so at a point when inflation averaged close to 5.36% as per the Consumer Price Inflation while the Private Final Consumption Expenditure Deflator shows the same to be 3.9% since 2014. Since 2010, PFCE shows the average annual inflation to be close to 5.9%. Thus, an individual will still get a stable real positive return in excess of 1%.

Many are pointing out that a real return of 1% is not enough, but the real rates across EMs are close to 1% if not lower. Moreover, we need to keep in mind that earlier with inflation in double digits, savers were obtaining negative returns. That is, inflation rate was higher than the rate of interest on their deposits. Thus, even with high nominal rate of interests, they were poorer in future. In contrast, now they are making a real positive return on their existing deposits and are thus better off.

There has also been an additional argument regarding lower rates having an adverse impact on the middle-class. Such a view is fairly myopic as it only views interest income on past savings often ignoring the complexity with which different variables interact in a modern economy. Yes, lower rate of interests would mean lower interest income on past earnings. But lower rate of interests also means lower cost of ownership of house — a prime asset used to store wealth by Indian household.

Further, the traditional channel of monetary transmission implies lower rates to boost aggregate demand – some part by consumption (consumer durables) and some part by capital formation. The consumption boost through rate cuts also results in an incentive for firms to add fresh capacity. Greater investments and competitive firms would result in India attracting a major part of the value addition process to its domestic economy. This ends up creating more jobs across a diverse skill level which provides a tighter labour market. A tighter labour market tends to benefit the middle-class significantly and the gains certainly outweigh any interest income that may be forgone by keeping interest rates low.

It is worth noting that even though the small savings rate may be kept low, but the real rates may still be positive, which is a significant departure from the earlier policy of negative real rates. Thus, even though people may think that the rates have reduced from say 10% to 6%, the real rates have gone up from — 2% to about + 1%. That is a 3-percentage point increase in returns for our savers.

Of course, this positive return is contingent on inflation remaining close to 4% on an average over the coming years. The MPC has as is been given the mandate to keep the inflation target unchanged for the next 5 years so there should be no reason to assume that the same will not be met. If inflation overshoots on account of overheating of the economy, repo rates may rise and so will the deposit rates — including those for the small savings. But the present inflation is on account of supply disruptions, lower trade volumes & higher operating costs. Post-normalisation of trade and the level of economic activity, inflation may revert to its natural tendency to be within the 3-6% range except for temporary periods when it lies outside the same.

The prospects of high inflation will depend on what happens to the prices of commodities in the international markets, which will in turn be determined by several factors, including the extent and pace of economic recovery post the pandemic over the coming few years.

But over a fairly longer period of times, inflation, nominal rates (and real rates) have moderated substantially across the world. This is a process that is driven by market forces and irrespective of the resistance to the same, eventually, we will have to bite the bullet & move to linking small savings rates with the repo rate.

(The writer is an economist and policy-researcher. Views expressed are personal)