Arvind Subramanian: when economists start talking like politicians, we have a problem


During the course of the last financial year, the finance minister Arun Jaitley, repeatedly kept asking the Reserve Bank of India (RBI) to start cutting the repo rate. Repo rate is the rate at which RBI lends to banks and acts as a sort of a benchmark to the interest rates that banks pay for their deposits and in turn charge on their loans.

The RBI finally cut the repo rate twice between January and March 2015. But this hasn’t been enough to get bank lending to start growing at a much faster pace. As of the end of October 2014, lending by banks over a one year period had grown by 11.2%. As of March 20, 2015, lending by banks over a one year period had grown by 8.6%. This, despite the fact that the RBI cut the repo rate twice between January and March by a total of 50 basis points (one basis point is one hundredth of a percentage) to 7.5%.

As I have often explained in the past, a fall in interest rate does not always spur consumption or lead to increased borrowing by corporate firms. As John Kenneth Galbraith points out in The Economics of Innocent Fraud: “If in recession the interest rate is lowered by the central bank, the member banks are counted on to pass the lower rate along to their customers, thus encouraging them to borrow. Producers will thus produce goods and services, buy the plant and machinery they can afford now and from which they can make money, and consumption paid for by cheaper loans will expand.”

But things play out a little differently in the real world. “The difficulty is that this highly plausible, wholly agreeable process exists only in well-established economic belief and not in real life. The belief depends on the seemingly persuasive theory and on neither reality nor practical experience. Business firms borrow when they can make money and not because interest rates are low, Galbraith points out.

Also, by taking about the RBI needing to cut the repo rate, over and over again, the impression that the finance ministry tries to send out is that the RBI is holding back economic growth. And that is really not true. If India has to grow at a much faster rate, then interest rates are just a very small part of the overall puzzle.
There is a lot that needs to be set right at the level of the government—from reforming labours laws to improving the ease of doing business to ensuring that the subsidies offered by the government reach the right people and are not stolen as they go down the system.

Over and above this, there are many projects stalled due to land acquisition issues, lack of environmental clearance or simply the fact that the firm carrying out the project is highly indebted. There is nothing that the RBI can do about these things. It can just hope to set interest rates.

Subramanian also went on to say that: “China is now cutting the interest rate quite aggressively in response to its growth slowing down…We need to respond accordingly.” This is a convenient use of facts as they are.

The People’s Bank of China has cut interest rates thrice since November 2014. In November last year, the Chinese central bank cut the one year benchmark deposit and lending rates by 25 basis points and 40 basis points to 2.75% and 5.6% respectively. There was another small change it carried out, which Subramanian did not talk about in the general statement that he made.

As Wei Yao of Societe Generale points out in a research note she wrote in November: “Along with the rate cut, the People’s Bank of China also lifted the upper limit that commercial banks can offer above the benchmark deposit rates to 1.2 times from 1.1 times. That is, the maximum permitted rate for 1-year deposits was 3.3% (3%*1.1) and is still 3.3% (2.75%*1.2). Given that commercial banks have been losing deposits recently, they will probably choose to stick to the upper bound.”

And what about lending rates? “As for lending rates, the lower bound to the benchmark lending rates was removed more than a year ago. In theory, there is no hard restriction stopping commercial banks from lowering loan rates anytime or by any amount. Therefore, the benchmark lending rate cut is also nothing more than a suggestion,” wrote Wao.

In end February 2015, the People’s Bank cut interest rates again. This time the one year benchmark deposit rate was cut to 2.5% from the earlier 2.75%. Further, the Chinese central bank increased the upper band of bank deposit rates from 1.2 to 1.3 times of the benchmark rates. What did this mean? “As a result, the maximum one year deposit rate that commercial banks can offer is now 3.25% (2.5%*1.3), only 5 basis points lower than the previous level of 3.3% (2.75%*1.2),” wrote Wao.

Earlier this month (May 2015), the People’s Bank cut the one year benchmark deposit rate again by 25 basis points to 2.25%. Nevertheless as Wao writes: “After the cut, the benchmark one-year deposit rate is now at 2.25%, but the ceiling is lifted to 1.5 times of the benchmark, up from 1.3 times previously. Hence, the maximum rate that banks can offer has actually increased from 3.25% (=2.5%*1.3) to 3.375% (=2.25%*1.5), which is even higher than the level (3.3%) at the beginning of this easing cycle.”

Hence, even though the People’s Bank of China has cut the one year benchmark deposit rate by 75 basis points since November 2014, the maximum rate that a bank can pay on its deposits has actually marginally gone up to 3.375% from 3.3% in November. In that sense, there has been no real cut in interest rates.

Now contrast this with India, where the RBI has cut the repo rate by 50 basis points since January to 7.5%. A 50 basis point cut is not very different from a 75 basis point cut. Further, deposit rates in India unlike China are not controlled by the central bank and many banks in India have reduced fixed deposit rates.

Though the cut in deposit rates has not been followed by a cut in interest rate on loans. In late April, the minister of state for finance, Jayant Sinha, had pointed out that, only 21 out of the 91 scheduled commercial banks in the country had cut their lending rates, after the RBI cut its repo rate twice.

To conclude, what this tells us is that Subramanian’s statement was too general to have been made of an economist of his stature. I wouldn’t have been surprised if Jaitley or Sinha would have made such a statement. But coming from an economist of Subramanian’s calibre, this is unacceptable. Also, the ministry of finance needs to realize that people who run the RBI know their job well and it is best if they are left to themselves to do it properly.


The column originally appeared on The Daily Reckoning on May 28, 2015  

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About vivekkaul
Vivek Kaul is a writer who has worked at senior positions with the Daily News and Analysis(DNA) and The Economic Times, in the past. He is the author of the Easy Money trilogy. Easy Money: The Greatest Ponzi Scheme Ever and How It Is Set to Destroy the Global Financial System , the latest book in the trilogy has just been published. The first two books in the trilogy were published in November 2013 and July 2014 respectively. Both the books were bestsellers on Amazon.com and Amazon.in. Currently he works as an economic commentator and writes regular columns for www.firstpost.com. He is also the India editor of The Daily Reckoning newsletter published by www.equitymaster.com. His writing has appeared across various other publications in India. These include The Times of India, Business Standard,Business Today, Business World, The Hindu, The Hindu Business Line, Indian Management, The Asian Age, Deccan Chronicle, Forbes India, Mutual Fund Insight, The Free Press Journal, Quartz.com, DailyO.in, Business World, Huffington Post and Wealth Insight. In the past he has also been a regular columnist for www.rediff.com. He has lectured at IIM Bangalore, IIM Indore, TA PAI Institute of Management and the Alliance University (Bangalore). He has also taught a course titled Indian Economy to the PGPMX batch of IIM Indore. His areas of interest are the intersection between politics and economics, the international financial crisis, personal finance, marketing and branding, and anything to do with cinema and music. He can be reached at vivek.kaul@gmail.com

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