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Suresh Krishnamurthy

THAT the real rate of interest is high continues to be the refrain of most economists. Prima facie, this is surprising because interest rates have declined significantly in the past five years.

However, there is a lot of truth in these statements. This is because the real rate of interest continues to be high for a section of the industrial community — manufacturers.

Simply put, real rate of interest is the difference between nominal interest rate and rate of inflation. Now, rate of inflation for manufactured goods is less than 1 per cent.

As such, the lending rates between 8 and 10 per cent for top-rated borrowers continues to be high.

For companies with lower ratings — which incidentally make up a substantial proportion of the total number of companies — the real rate of interest is substantially higher. Such real rates are not conducive for making investments and, hence, the concern about the high real rate of interest.

The high real rates for manufacturers are, however, only half the story. With the fall in nominal interest rates, the real rate of return for savers has also come down sharply.

Consider the consumer price index for urban non-manual workers. The rate of inflation is around 4.2 per cent for the year ended February 2002. With one-year interest rate hovering at 5.5 per cent, the real rate of return is a measly 1.3 per cent.

In fact, in the case of cities, such as Chennai (where the rate of inflation is 9.5 per cent), the real rate of return is substantially negative.

In fact, there is a convincing argument that the CPI inflation estimates understates inflation.

This is because the CPI does not take into account properly the rate of inflation in services, such as housing (rent), education, retailing and healthcare. The rate of inflation may be still higher if these are factored into the price index. While savers are reeling under such patently low real return and rising taxes, there is, unfortunately, no official lobby to voice their grievances.

While the RBI Governor, Dr Bimal Jalan, takes note of the higher real rate of interest for manufacturers, the plight of savers is left unnoticed. This makes it far easier for the establishment to impose unjustified policies such as the increased taxation and lower real rates of returns.

However, such policies may be counter-productive. It can only perpetrate the vicious cycle of lower savings, lower investments, lower growth, lower tax revenues and, thus, imposition of even higher taxes in the future.

As such, it is important to address the dichotomy in the real rate of interest for savers and manufacturers. This will require an attempt to curb the rate of inflation in the services sector.

That again requires a reduction in the rate of growth in money supply. However, with ever-increasing government borrowings, money supply growth may remain high.

The situation does not augur well for savers. They have to plan their consumption and investment in a manner that reduces the impact of inflation and lower returns.

For instance, buying a house financed with loan is an excellent proposition. That will ensure that a hedge against rent inflation is obtained, and secure tax benefits.

In addition, a higher proportion of saving needs to diverted to the equity market.

The higher returns in stock market can help combat inflation in the long term. Overall, the need for caution cannot be over stated.

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