What should be real interest rate for India? Experts debate

Dr Rangarajan, Former RBI Governor and proven inflation warrior in India, Jahangir Aziz, Chief Economist, JP Morgan and Eswar Prasad, Professor of Economics from Cornell University, discuss on the same.

Below is the transcript of the interview with CNBC-TV18’s Latha Venkatesh

Q: What do you think should be the real rate in India? Will savers be content with one percent?

Rangarajan: There is no easy way of determining it. There is a proof in economic theory that in a purely closed economy the real rate of interest can be equal to the real rate of growth of the economy. Therefore it can go as high as that but this is not valid in an open economy. That holds good purely in a closed economy.

Everyone realises that savers particularly need a real rate of return on their deposits or on their assets. Therefore in some sense it depends upon the level of savings that one wants to have in the country. If the demand for savings is higher then obviously we should be willing to pay a higher real rate of interest. I certainly think that an Indian investor, or Indian saver is really looking for a real rate of return which is above 2 percent, I think it is closer to 3 percent. This again is a guess, there is no way of purely determining it but if you want actually a higher level of savings in the economy we should work towards something like close to 3 percent real rate of return as far as the financial assets are concerned.

Q: In that case if the informed guess of average inflation for 2015 is 5.5 percent then your 2.5 percent would mean that we are already not giving a very good real return at 7.75 percent. At least we should not give too many more rate cuts, lest we scare away savers.

Rangarajan: The average of 5.5 percent is something that we need to re-check. In fact all projections of RBI on this core have gone awry. The inflation rate today is way below the glide path that was indicated. Therefore one could expect the inflation rate to be somewhat lower than the number that you are talking about. After all if you look at it in terms of the wholesale inflation, that is fairly low and I do not think that probably we are looking for 5.5 percent in the coming year. It will be lower than that and therefore that further cut in repo rates are possible. Anything should be done in relation to what is happening actually at the ground level.

My own expectation is, given the way in which inflation has behaved in the recent period perhaps we might be closer to between 4.5 and 5 percent on an average. Therefore even if you have a 2.5 percent real rate of interest, it is something like 7 percent. Therefore there is certainly a leeway to go. There is possibility of further reductions up to a total of 100 basis points during the year.

Q: Is there a real rate which is common across countries?

Aziz: No, because your real rate is essentially determined as Dr Rangarajan said, more or less in the medium term by your real growth rate. The nominal rate of course will equalise across countries if you have open capital markets which means that inflation adjusts so that your real rate and your real growth rate more or less has some sort of a relationship over a average over the medium term.

Q: Now, let's come to India, what would you say is the good real rate for India?

Aziz: The way in which we would want to look at this thing is, let's pick up a time period in India where we think things were stable and I want to use the word normal but just can't use the word normal but more or less stable. So, you had really decent growth rate, you had a pretty stable inflation rate, the current account deficit did not blow up , the rupee more or less was stable etc. So, broadly we are talking about that period, 2003 -2007, not even 2008 and if you look at that period of time, potential growth probably at that time was about 8.5 percent and if you look at real policy rate at that point in time that is where you get that 200 basis points or 2 percent real rate. That is where you want the policy rate to be.

Without going into 5 percent, 5.5 percent, what will be next years’ interest rate, let's take 6 percent which is their target and 4 percent, the target after 2016, which is where they really want to be. You take an average of 6 percent and 4 percent you get that over the medium term if RBI more or less manages to keep the inflation expectation under control, they will keep inflation around 5 percent. So that is where you get a 7 percent nominal policy rate. Now, 2 percent real plus 5 percent inflation gives you a 7 percent nominal policy rate. You are at 7.75 now, the question is that do you want to give the entire 75 basis points now or do you want to even give more than 75 basis points. In other words you want the real rate to be even lower, why because growth is actually lower than the potential growth rate right now, hoping to make it up later on. So that is the way you calculate it.

Q: Let me get Dr Rangarajan's response on this.

Rangarajan: When you talk about the real rate, there is not one real single real rate. You are talking about the real rate for the policy repo and there is a real rate for long term savings. When I talked about 3 percent as the real rate of interest I am thinking in terms of the long term savers, whereas the repo rate is basically a rate which is your short term interest rate. Therefore we need to make a distinction between the real rate of interest for a short term transaction and for medium term and long term transactions. Therefore 3 percent real rate of interest for savers is appropriate and perhaps the policy rate need not necessarily have a 3 percent real rate of interest.

Q: Since you were instrumental in bringing down the inflation level from double-digit levels in your own time, the RBI has take a fairly ambitious target of 4 percent inflation as suitable or as possible for India. If you compare this to the historical rate of inflation in India, the average of 70 years is 7 percent if you looked at the Wholesale Price Index (WPI) almost 6.9 percent. If you looked at consumer price index (CPI) industrial workers, then the average has been actually 8 percent. Do you think it is too tall a ask of 4 percent that the Urjit Patel report has set for next year? Is the political economy too comfortable with that 7 percent inflation and therefore it will resist 4 percent?

Rangarajan: There are two types of answers to your question. First is that the very high inflation rate that you have got or that you have calculated is over a very long period. There was a period in the Indian history, in the post independent period when many people talked about inflation almost being endemic in economic growth. It is this which led to very sharp increase in prices. You remember in mid 1970's, the wholesale price inflation not only touched double digits, it went almost up to 20 percent. Therefore those days are gone and if you naturally look at after 1992-1993 or 1993-1994, the level of inflation is much lower on the wholesale price index. Therefore it is possible.

The other answer is that while 4 percent is the desired level, the argument is that it could range in a zone of 2-6 percent. 2 percent let us leave it out, let us look at the upper end of the zone, it is 6 percent. Therefore strong action is required when the inflation rate actually exceeds 6 percent. Therefore I would think that yes, 4 percent is the most desirable level but actually strong action is required when it exceeds 6 percent. If you look at it that way, I do not regard the target set as being ambitious and it is most desirable to achieve it because world over the inflation has come down and India cannot be an exception to that.

Q: My question is the political economy appears to be comfortable with 7 percent inflation, so will it resist actions towards 4 percent?

Aziz: My guess is that 7 percent inflation rate with which the political economy, “was comfortable with” was when growth was also 8.5 percent. You now no longer have the luxury of 8.5 percent growth rate so that real incomes were pretty large and growing very fast. If your real growth rate is now down to 6-6.5 percent, I really don't think that the same population would now be willing to live with a much higher inflation rate than let's say a 4 or 5 percent.

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Q: Governor Rajan has mentioned that 1.5-2 percent is an appropriate real rate as prevailing in most countries. Is there any theoretical justification for this 1.5-2 percent?

Prasad: There is nothing really sacred about 2 percent. However for an economy of India's size and dynamism with a 2 percent real interest rate you can easily get the sort of growth rates that we think India is capable of achieving, something in the range of about 7-8 percent.

However every time I go back to this point that it is the real interest rates that needs to be seen in combination with what else is happening in the economy. If you have the real interest rate at 2 percent that means relatively low price of capital and if all the supply side constraints are removed that can generate a lot of growth. However, if you have a real interest rate at 2 percent or even lower and you don’t have a supply side constraints being removed that doesn’t generate the right sort of inflation growth dynamics that one would like to see in the economy.

So, we cannot see the real interest rates in isolation from all the other policies that the country very much needs in order to promote high growth. It is certainly going to help a great deal if we can continue bringing down both nominal and real interest rates and ideally lot of this should happen in an environment where inflation is falling and productivity growth is rising.

Q: If we assume that 2 percent real rate is appropriate and if as forecasted by Arvind Subramanian and the RBI inflation averages 5.5 percent in 2015 then we don’t have much room to cut rates from the current 7.75 percent?

Prasad: That is true that if you think about where the inflation rate is expected to be in 2015 that doesn’t mean much more monetary policy action is needed. However the hope is that the inflation rate is on a downward trajectory so rather than focusing on the very short term and where interest rates should go, we should be thinking about a 2-3 year horizon and what the trajectory of both nominal and the real rate needs to be over that period.

So, can the Indian economy support a real interest rate that is even lower than 2 percent, the answer to that again is a conditional one. I do not see why we cannot have a lower price of capital in India especially given the very low price of capital in the rest of the world if we can get other aspects of policy in the right shape.

However the excessive focus on trying to bring down the real interest rate in the short run really detracts from what monetary policy can and cannot do and what the other mix of policies needs to be doing.

Right now I think we are at a very good conjuncture because the growth momentum in India is picking up, productivity growth in the manufacturing sector has not done quite as well but is beginning to show signs of improvement plus the inflation rate and the current account deficit are all on the right trajectory. So, it is a good time to be thinking about getting the whole mix of policies in a manner that can support growth. Lower interest rates are certainly a part of it but only a part of it.

Q: India's historical average inflation rate is 7 percent. Rajan wants to see it at 4 percent. Would that require an even higher real rate?

Prasad: The question is what the right level of inflation is for India in order to achieve a variety of objectives. First of all you want inflation to be pinned down fairly well. So, inflationary expectations are also reasonably well anchored. You do want to have a reasonably moderate level of inflation so that you can get wage price adjustment especially adjustment of relative prices in the economy.

So, in many advanced economies the notion is that an inflation target of somewhere in the range of 2 percent works well for those economies in terms of those objectives. In India given many of the structural issues that we have an inflation target that is somewhat higher certainly makes a lot more sense. There is nothing magic to the number of 4 percent or 5 percent. However having inflation much beyond 4 percent makes it much harder to manage inflationary expectations.

My own view is that while this seems like an ambitious target given our history, what the RBI is trying very hard to do is make the point that in India with monetary policy being run the right way and with support from fiscal policy and other policies the economy can sustain a significantly lower inflation target than the case based on history. This will be very good for the economy in terms of providing the sort of macro economic stability that you can get from low and less volatile inflation.

Q: How many countries have managed to move from such high average inflation levels to low single digit levels? How did they accomplish it?

Prasad: There are countries that have managed it. If you take a country like Brazil that had historically a very high inflation rate, put in place an inflation targeting regime and was able to bring down inflation very quickly and in fact right after that happened you had a very positive outcome in terms of growth. However what was necessary for that to happen was not only that the central bank was able to set the target in cooperation with the government because if the central bank in an emerging market in particular sets a target without the government committing to do its part it is never going to work.

However there are historical instances where we have moved from very high inflation to a much lower level of inflation. In Brazil the inflation target is somewhat similar to what the Reserve Bank of India is aiming for. It came with good growth outcomes. Of course the Brazilian economy is now not doing very well for a variety of other reasons but when the inflation target was put in place it had a broad amount of political support because it was clear to the politicians and to the general public that very high inflation was hurting the economy.

However this is what it ultimately comes down to, whether you get to the 4 percent in a reasonable period of time and with the right mix of policies. Again I think that India is moving in the right direction on all of these fronts. So, I think 4 percent target is not only attainable but in the long run could be good for India.