Political economy of interest rates
Business Standard, December 18, 2002
Tax exemptions on small savings instruments are distortions introduced in the market for funds
Finance Minister Jaswant Singh seems to be trying to reverse the direction of interest rate reform in the country. On December 13 he announced in Parliament his decision not to remove tax exemptions on housing loans.
A few days ago he had said that senior citizens would receive higher interest rates on bank loans. Also, the mid-year credit policy in October did not make the savings deposit rate market determined or even reduce it as was expected.
The finance minster, no doubt, has ample political support for continuing tax exemptions on home loans. Not only have tax exemptions made housing available for lakhs of households, they have also boosted the housing sector and helped revival of industry in the last few months.
Yet, this does not change the fact that tax exemptions on home loans or on small savings instruments are distortions being introduced in the market for funds. Genuine concerns for industrial growth, senior citizens or the middle class should not cloud our perception that these moves are a reversal of the progress towards market determined interest rates.
A significant aspect of the post 1993 reform in financial markets was the freeing up of interest rates.
The move away from administered rates to market determined was an attempt to make financial markets more efficient and allow money to flow where it was most productive. The purpose was also to increase the efficiency of the economy by aligning the cost of funds to the rate of time preference and the return on capital.
The purpose of tax exemptions and special rates is to ensure that interest rates paid by a group of borrowers are lower than the market rate, while those received by some lenders are higher than the market rate.
Since the government no longer wishes to administer the housing loan interest rate paid by banks, it steps in and makes the loan cheaper by offering borrowers tax concessions.
The former step would have put the burden of lower than market rates on banks. Now the government bears this difference. Though rates may no longer be administered, the distortion in the market does continue and can result in inefficient allocation of resources.
The difference between the market rate on home loans and the rate effectively paid by the borrower or the tax exemption is the burden being borne by the fisc. Similarly, the difference between the market interest rate and the rate paid on small savings (as well as the tax exemptions being given for such savings) constitute the burden on the exchequer.
The hit that banks would have taken if the government had administered interest rates, is now borne by the budget.
It is not just the government who pays a price for interest rate distortions. Households who would have invested in financial assets, human capital and housing according to their needs would tend to invest more in housing when that becomes cheaper. Thus the portfolio choice of households gets affected as well.
The recommendations of the Y.V. Reddy committee on administered interest rates for small savings and more recently the Kelkar committee’s proposals for removal of tax exemptions address the two related issues of making interest rates market determined and of removing from the fisc the burden of making these loans cheaper or deposits more expensive.
However, the downward movement of interest rates over the last four years has sharpened conflicting interests between the borrowers and the lenders. The government itself is the biggest borrower and clearly stands to benefit from the reduction in interest rates.
The period after 1997, when many argued that the industrial slowdown was a consequence of high real interest rates, was characterised by pressure on the government to reduce rates. Former Finance Minister Yashwant Sinha went out of his way to lower the cost of borrowing. RBI and the ministry of finance colluded to reduce interest costs for borrowers.
Regardless of how they are measured, there is no doubt that nominal interest rates declined. Whether measured by the lending rates of banks, by the rate on government bonds, or the rate on time deposits of banks, greater flexibility was introduced and rates were reduced.
One consequence of the reduction in interest rates was that it brought down the cost of borrowing for the fiscally constrained government. The reduction in interest rates paid a significant part in preventing the Indian economy being pushed into an internal debt trap. The interest to GDP ratio that had been on a rising trend was contained in this period.
But even though Sinha did not reduce interest rates received by depositors such as the interest rates on small savings or the saving’s deposit rates to the same extent, and rigidities continued to plague the system, his policies attracted the ire of middle-class voters and BJP cadre.
Also, industry was not terribly sure that the combined fall of interest rates and inflation really reduced interest rates. While lending rates for large borrowers came down significantly, that for small borrowers fell much less.
But more so, the impact of the fall in the growth of prices and the continued demand recession did not allow the reduction in nominal rates to have the kind of impact they could have had.
Consumers felt that consumer prices did not fall as much as the interest rate on their deposits and their real interest income shrank. The availability of cheaper consumer loans did not have adequate impact on vocal interest groups.
Banks felt that lending rates were falling faster than deposit rates and their net interest earnings were declining. Reducing interest expenditure of the government did not help Sinha much as there aren’t many in the electorate who worry about fiscal deficits.
Jaswant Singh’s mandate appears to be to win back some of those who felt aggrevied by Yashwant Sinha’s policies. But any such moves will not merely distort the market but put a burden on the exchequer.
Today tax revenue barely covers interest payments, defence and subsidies. There is no scope for largess to various pressure groups. Moreover, interest rates should not be a means to win political support.
The more distortions that exist in the market, the lower is the effectiveness of interest rates, an instrument of monetary policy, the less effectively they can be used for short-term macroeconomic policy.
Mr Singh may well win the political support of a few vocal groups if he continues to use interest rates to buy votes, but the policy of the government taking on an increasing burden of tax distortions is inherently harmful to the health of the fisc and ultimately to the economy and the poor as the money could have been better spent on infrastructure and clean drinking water.
Indeed, the money lost if spent on better provision of public services could have benefitted many more poorer households than the handful of those benefitting from the concessions.
(The author is at ICRIER. These are her personal views)