Should RBI cut interest rates now that there is evidence of a slowdown in investment and output? Will an interest rate cut increase stability in inflation, the rupee, the current account, capital flows and GDP growth?
The most dramatic development witnessed in recent days has been the high volatility in the foreign exchange market and a depreciation of the rupee. The pressure on the rupee has come about due to a decline in capital flows, while the current account deficit has risen to 4% of GDP, as the savings and investment gap has increased compared to previous years.
The latest CSO data for savings and investment shows that savings fell by more than investment as a share of GDP. Household savings dropped from 25.4% of GDP in 2010-11 to 22.8% of GDP in 2011-12. This drop, of 2.6% of GDP, in household savings came about mainly due to the fall in household financial savings. In 2010-11, household financial savings stood at 12.9% of GDP. This fell to 10% of GDP in 2011-12. This was a fall of 2.9% of GDP which accounted for the lower household savings ratio.
The fall in household financial savings was a consequence of the low real interest rates households earn on their savings. The year saw a reduction in the growth of bank deposits and small savings. While the inflation rate has risen, interest rates have not risen accordingly and it is unattractive for households to save money in bank deposits. Higher inflationary expectations are now embedded in the minds of households and if a bank deposit offers an interest rate of 8%, it no longer induces households to save money in bank deposits.
At the same time, considering the inadequate social security system and lack of pensions and health benefits for the bulk of the population, the need to save remains. Households prefer to save in real estate and gold. As the CSO data shows, physical savings of households continued to be high and even rose slightly from 12.4% of GDP in 2010-11 to 12.8% of GDP in 2011-12. This has two key effects. One, real estate prices remain high and if real interest rates on bank deposits remain low, they create the conditions for an asset price bubble. Two, when households move to gold as a financial asset, the demand for gold, which has a high import intensity, rises and more gold is imported.
Inflationary expectations of households