The Hindu : How one thing leads to another

Online edition of India's National Newspaper
Tuesday, May 20, 2003

Business

Business

How one thing leads to another

By Prem Shankar Jha

Ten days ago, when the Governor of the Reserve Bank of India, Bimal Jalan, announced yet another quarter per cent cut in the Bank Rate, bringing it down to 6.25 per cent, the lowest it has been since India attained its independence and a similar cut in the cash reserve ratio to 4.75 per cent, he was met not with approbation but a deafening silence. The silence reflected a growing sense of desperation in the Indian middle class and the first signs of hostility to the Government's policy of lowering the cost of borrowing. Somewhat to his surprise Dr. Jalan found himself facing a barrage of hostile questions from reporters. Even the correspondents to whom he gave one-to-one interviews were decidedly cool to his policies.

The tenor of the questioning reflected the mounting concern of the middle class. When the inflation rate had climbed to 6.2 per cent at the end of March, would the reduction in the Bank Rate not bring the real rate of interest close to zero? Another cut or a further rise in the rate of inflation would make it negative. The commercial banks had shown great alacrity in responding to previous cuts in the Bank Rate and the CRR by lowering the interest on deposits sharply. These had come down so far that a very large section of the population, mainly retired civil servants and professionals, which lived on the interest it earned on its savings, had suffered a drastic reduction in its income and begun to feel seriously threatened.

Dr. Jalan tried to explain that this perception was not accurate. The inflation rate had been driven up during the previous three months by sharp increases of price in a few sectors that had been affected by last year's drought and by the rise in oil prices before the Iraq war. These prices were expected to come down soon. The core rate of inflation, the one that mattered to industrialists, was only 2.5 per cent. What is more, for borrowers, the real rate of interest had not really come down. The Prime Lending Rate, the rate at which blue chip companies could borrow money from the banks, was still around 9.5 per cent. Thus, to them the cost of borrowing in real terms was still a prohibitive 7 per cent or thereabouts. For most other manufacturers and traders it was somewhat higher. Dr. Jalan conceded, however, that both the Bank Rate and the CRR had come down about as far as they could.

Why should there be so much hostility to a lowering of interest rates? According to orthodox monetary theory, lower rates lead to a rise in share prices. Savers gain in one market that they lose in the other. In fact they do more than that, because the lower interest rates stimulate investment and economic growth. This swells profits and raises share prices still further. Investors should therefore welcome opportunities to switch their savings from bank deposits to the shares.

But this is not happening. Investors are so terrified of the share market that they prefer to bear almost any loss in the money market, rather than switch their savings to shares. As a result, today, even the most conservatively run mutual funds are posting losses. The bulk of the middle class therefore feels utterly helpless. Keeping the real rate of interest down may be necessary, but a single per cent fall in deposit rates from 8.5 to 7.5 per cent causes a 13 per cent loss of income to them. But in the past five years bank rates have been dropped by a full 5 per cent, and deposit rates have come down by a full 4 per cent on longer term deposits.

Why does the stock market inspire so much fear in ordinary investors? One answer is the succession of scandals by which it has been rocked over the past 11 years. The 1980s had seen a dramatic transformation in the savings habits of the people. From holding over nine tenths of their savings in bank deposits they had branched out into a wide variety of financial instruments which had come onto the market during that decade.

The most successful had been convertible debentures, which offered both security and capital appreciation The miraculous performance of Dhirubhai Ambani's Reliance Industries in particular fired the imagination of an entire generation of the new urban middle class.

It is true that hundreds of thousands of small investors were swindled out of their savings by embezzlers and crooked brokers who floated phantom companies, issued junk bonds, got these companies listed on the Bombay Stock Exchange, and disappeared with the money they had raised. But the winners greatly outnumbered the losers. The share market therefore looked both a safe and quick way to affluence.

The Harshad Mehta share price rigging scandal in 1992 burst the bubble. Millions lost their life's savings in the stock market crash that followed. As if that was not bad enough, another crash occurred four years later, brought on by mindless anti-inflation policies of the Government of the time, which killed the boom in private investment and turned the industrial boom of 1992 to 1996 into a prolonged stagnation that continues till today. The second crash destroyed the Unit Trust of India, which was the Government's flagship mutual fund. Twentyfive million shareholders found their life's savings cut in half. It is no surprise that no one wants to venture into the share market gain.

At the root of the disjunction between the money and share markets, lies the ever rising fiscal deficit of the Indian State. At 11 per cent of the GDP, it has crowded private corporate investors out of the money market. With the Government ever willing to borrow from the banks (39 per cent of their deposits are locked up in government securities) the commercial banks have felt only limited pressure to lower their lending rates. That has widened the gap between nominal interest rates and inflation, raising the real rate of interest from 3.5 per cent in 1996 to 7 per cent in the last three years.

The rising real rate of interest has been reflected in a stagnation of share prices. This has left investors with almost no other choice but to keep their money in bank deposits and suffer losses in income. Deprived of an option their wrath is rising, and turning political.

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