Negative Interest, Financial Repression


Mr Pradeep Kukreja is all smiles these days. His bank has raised its deposit rates. Kukreja’s two-year fixed deposit matured last week. Instead of redeeming it, he reinvested it for another two years. This time, he will earn 6 per cent interest.

Since he prefers to earn cumulative interest, his actual earning will be around 6.14 per cent for the year. This means, his Rs100 will become Rs106.14 after a year. Right? Wrong.

Earning more than Rs10 lakh a year, he would need to pay 30 per cent income tax on his interest income. That makes it Rs104.30. Right? Wrong, again.

As the inflation for the current financial year is projected to be 6.7 per cent, his Rs100 deposit would actually become Rs97.60, even after earning 6.14 per cent interest.

For Kukreja and the community of savers in India, the value of money is being eroded by high inflation. After the Reserve Bank of India (RBI) raised its policy rate by 0.9 per cent in the June quarter to fight inflation, banks have raised both their loan and deposit rates.

As inflation eats out the value of money, everyone is talking about the “real” interest rate. How much interest should one get from the government’s small savings schemes and how much from bank deposits and other saving instruments?

The exact quantum of real rate depends on the state of the economy, but how do we calculate the real rate? By definition, the real interest rate is the rate of interest a saver expects to get after accounting for inflation. Going by the Fisher Equation, the real interest rate is approximately the nominal interest rate minus the inflation rate.

This is fine, but what is the ideal benchmark rate to calculate the real interest rate? Should it be bank deposit rates? If indeed that’s the case, do we need to see how much one is earning after paying income tax? If not bank deposits, should it be the central bank’s policy rate? Or, the 10-year bond yield? Or, the yield of a one-year treasury bill?

Thanks to high inflation, almost the entire world is experiencing a negative real rate – the value of money is going down.

This is not the first time that the savers in India are seeing their money losing its purchasing power. The real interest rate was negative in 2013 when inflation was in double-digits for months. Between 2012 and 2014, for three successive years, the average inflation was 8.22 per cent, making the real interest rate negative for savers.

Former RBI governor Raghuram Rajan spoke about keeping the real interest rate at 1.5-2 per cent. At an analysts’ conference in 2015, after presenting the monetary policy, he explained that the benchmark could be one-year treasury bill yield for calculating the real interest rate (one-year treasury bill yield vis-à-vis expectations of inflation over the one-year ahead). Of course, he added that “the natural real rate is a moving object… It depends on the state of the economy… I do not think this… is cast in stone.” But given the prevalent conditions, 1.5-2 per cent should then be the real interest rate.

If we take the one-year treasury bill yield as the benchmark, then we have a negative rate of 0.56 per cent now (6.7 per cent minus 6.14 per cent = 0.56 per cent). It will remain so for quite some time.

Unlike the policy rate, which is determined by the rate-setting body of the RBI, the treasury bill yield depends on many factors, including liquidity in the system and foreign funds flow.

Assuming a normal monsoon and average crude oil price of $105 per barrel, the RBI has projected inflation at 7.5 per cent in the first quarter of FY 2023; 7.4 per cent in the second quarter; 6.2 per cent in the third; and 5.8 per cent in the fourth quarter, ending in March 2023. In February, it had estimated just 4.5 per cent average inflation for FY23. The Russia-Ukraine war and its impact on oil price, among other things, forced it to raise the estimate to 5.7 per cent in April before it was hiked to 6.7 per cent in June.

RBI Deputy Governor Michael Patra recently said, “We will be able to bring inflation back to target within a two-year time span.”

What is the target? In a recent interview with Business Standard, Finance Minister Nirmala Sitharaman said, “… 6 per cent is a sacred number for me. We …want to bring it down to somewhere close to 6 per cent or below 6 per cent.”

The inflation target is 4 per cent with a band of 2 per cent on either side, but it seems that it has shifted to the upper end of the band. In April, retail inflation was at an eight-year high of 7.79 per cent, almost double the target.

It was over the 6 per cent band for 10 months between March and December 2020. The central bank owes an explanation to the government if it fails to contain inflation within the target for three successive quarters. However, this was not done because data might not have been accurate when the economy was reeling under the Covid-19 pandemic in 2020.

Retail inflation has been above the upper limit of the central bank’s flexible inflation target band since January 2022 and, by RBI’s own projection, it will remain so till December. This means, the central bank will have to explain to the government why it has failed to achieve the target for three successive quarters.

While we wait for this, let’s hope that the flexible inflation target does not meet the fate of the Fiscal Responsibility and Budget Management (FRBM) Act. Enacted in 2003, FRBM had set the target for the government to reduce fiscal deficit. It mandated the central government to bring down its fiscal deficit to 3 per cent of the GDP by FY2008 but the target has been extended several times.

In May 2016, the government had set up a committee under NK Singh to review the FRBM Act. The committee recommended a fiscal deficit of 3 per cent of the GDP in years up to March 2020; 2.8 per cent in 2020-21; and 2.5 per cent by 2023. Ravaged by the pandemic, in FY2021, the fiscal deficit was 9.3 per cent of the GDP, which was pared to 6.71 per cent in FY22. The current year’s projection is 6.4 per cent. Nobody talks about FRBM anymore.

While we hope that the inflation target architecture does not go the FRBM way, the question remains: How long will financial repression for savers continue and how do we compensate them? The only way to bring the real rate back to the positive territory is monetary tightening. There is no escaping that.

Otherwise, India’s gross savings rate will continue to fall. After hitting 32.07 per cent of the GDP in FY18, it has been falling every year. In FY21, it was 28.24 per cent, falling from 36.9 per cent a decade ago. Investments drive growth but how will investors get funds if the pile of savings shrinks with no incentive to save in a negative interest rate regime?

It’s another matter that a negative interest rate is pushing savers to riskier assets. It’s also adding to the current account deficit, posing a threat to macroeconomic stability.

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