BackReal interest rates and financial savings
In India, the substitution effect of real interest rate is more than the wealth effect leading to overall negative impact of higher interest rates on savings rates
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There is an ongoing debate in this paper regarding the current monetary policy stance of the Reserve Bank of India (RBI). While one school believes that the current policy stance should be neutral, the other school believes that the policy should continue to remain tight. Both, however, are linked with a common thread: private saving vary with the real interest rate. This can be objected to. Evidence suggests such an association may not be theoretically or empirically accurate. If this is case, then the entire focus of such a debate may be misplaced.
In 1973, economists Ronald McKinnon and Edward Shaw postulated a relationship between high interest rates and private savings. In theory, high real interest rates have two opposing effects on private savings. The first is the substitution effect, in which saving increases as consumption is postponed to the future, and the second is the wealth effect in which savers increase current consumption at the expense of saving. The impact of real interest rates on private saving is, therefore, ambiguous and can only be established empirically. Further, McKinnon and Shaw said that under conditions of financial repression, the substitution effect dominates the wealth effect, thus enhancing financial intermediation.
What is the empirical evidence in economic literature? Here again, the results are mixed. Empirically, some economists have found savings to be insignificantly related to real interest rates, while others have found a small but positive interest rate elasticity of savings.
More crucially, in the Indian context, studies show the substitution effect of real interest rate is more than the wealth effect leading to overall negative impact of higher interest rates on savings rates. However, the actual coefficients are significantly small and insignificant in most of the cases. The coefficient ranges from 0.1 to 0.3, suggesting a large change of as much as 3% to 10% in real deposit rates will be needed to change savings rate by 1% and small changes will hardly make any difference, if any.
Additionally, causality analysis in India between income per capita and savings rates shows that such causality run mostly from income to savings. This implies that high gross domestic product (GDP) growth and increase in per capita income would significantly improve the savings rates in India.
Let us now juxtapose such findings in the current Indian context. After hovering in the negative territory for nearly 21 months, the real interest rate is now floating in the positive zone. If RBI leaves the rates unchanged in the coming policy review, the real rates would reach as high as 3.5% during November by taking the Consumer Price Index (CPI) as proxy and 7.2% if the Wholesale Price Index (WPI) is taken as proxy.
Interestingly, it will lead to a situation where real interest rates will be higher than nominal interest rates for most banks in the deposit category of less than one year (upto 90 days). This will be way above the 0.5% (CPI) and 1.5% (WPI) real rate prevailing on a cross cyclical basis in India.
There is another issue here. What will be the equilibrium real interest rate in India? Our take on the expected real interest rate is that it should be ideally around 2% (repurchase rate at 8% and desired CPI at 6%), if we go by RBI assumptions of 6% monetary targeting. However, we must add that the equilibrium real rate is not constant throughout the different business cycles, so it should be lower than 2% today, especially since firms and consumers face different real rates.
This brings us to the final question. How do we increase financial savings if real deposit rates are not the only reason? We believe the launch of Pradhan Mantri Jan Dhan Yojana, a financial inclusion scheme under which the government intends to provide every household with a bank account and insurance cover, will lead to better access to banking and promote private savings in a developing country such as India.
This apart, an increase in optional contributions to the public provident fund as decided in the budget will still encourage Indians to save more to meet their expected retirement benefits. This will also be enabled by the significant increase in life expectancy in India in recent years, which is now 82 years at retirement.
Additionally, Indian households necessarily have a stronger bequest motive so that a positive effect of anticipated retirement benefits can be expected. All in all, an increase in financial savings may be also expected because of the recent government changes.
These arguments are in no way meant to imply that real rates should not be positive. An increase in inflation does impact income and wealth negatively, lowering savings. Inflation rates can only impact savings positively if people foresee that such inflation indicates macroeconomic uncertainties. In a country such as India, where food inflation shocks are endemic, such a possibility looks weak, assuming the shocks from the exchange rate are minimal.
Soumya Kanti Ghosh is chief economic advisor, State Bank of India.
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