Opinion: RBI’s policy room will shrink as India ages
It is imperative that the RBI put in place a macro-prudential framework that protects against adverse demographic occurrence
In the recently concluded third bi-monthly monetary policy meeting, the monetary policy committee (MPC) hiked the repo rate by 25 basis points to 6.5% citing elevated headline inflation figures and a robust growth scenario. Not only was the policy action along expected lines, but the factors influencing the decision also comprised the usual bets.
On the inflation front, elevated crude prices, the rising costs of health and education, an uptick in household inflation expectations, and the impact of the staggered implementation of house rent allowances by states are expected to keep headline inflation high. On the growth front, a better industrial outlook, robust production in eight core industries, including cement and steel, strong rural and urban demand as reflected in tractor, two-wheeler and passenger vehicle sales, and rising domestic air traffic passenger growth bode well for the economy in the short term.
These factors, in addition to the uncertainty resulting from geopolitical risks and rising trade protectionism, prompted the MPC to hike the repo rate. The previous rate hike in June also came against the backdrop of the same factors. There is another structural factor, however, which is far less discussed in routine monetary policy statements. Yet, it deeply influences the interest rate dynamics through its impact on economic variables such as savings, investments and incomes: India’s adverse demographic developments.
An International Monetary Fund (IMF) paper (goo.gl/3gD1gU) published last month discusses the transmission of the changing demographic structure in emerging countries to interest rates. The global financial crisis (GFC) of 2008 had led most advanced and emerging countries to pursue accommodative monetary policies, resulting in low real rates across the globe. The paper argues, however, that real rates have been falling globally for more than two decades, though the GFC may have accelerated the process. A major reason behind this phenomenon is the demographic transition propelled by fundamental changes in fertility and longevity. Both these factors influence interest rates through their impact on savings and investment. Young households, for instance, tend to borrow against their future income while forgoing savings. In a country with a relatively greater proportion of younger people, this bias towards borrowing increases the savings-investment imbalance by reducing savings. In other words, the demand for borrowed funds trumps supply, causing the real interest rates to rise.
Old-age households, on the other hand, dissave against their past savings. But the effect on interest rates for countries with a greater proportion of old-age households is rather mixed. This is because, on the one hand, the tendency of old-age households to dissave pushes up interest rates. On the other, the relatively lower proportion of labour force in such an economy causes the capital-labour ratio to increase. There is now a greater availability of capital and relatively lower demand for investments. This pushes interest rates down. The IMF paper, however, found that in such economies, the investment channel normally tends to dominate the savings channel. The net effect is a decrease in real interest rates.
What does this mean for India? According to IMF calculations and a UN report, World Population Prospects: 2015 Revision, India’s old-age dependency ratio—the proportion of old-aged people to the labour force—is set to increase from 15% to 20% in about 12 years. This speed of aging is staggering compared to many advanced economies. The US, for instance, took about 50 years for the old-age dependency ratio to increase by the same proportion. The point being that youth dependency, a characteristic that defined India’s demographic structure for the past few decades, is declining at an increasingly faster rate. This is expected to reduce real interest rates in the future as investment demand from a declining proportion of young households in India reduces more than the decrease in savings prompted by the increasing proportion of old-age households.
The potential decline in real rates, induced by the adverse demographic developments, would partly reflect the potential decline in the real natural rate of interest. The natural rate of interest is the rate at which the economy grows at its potential, characterized by full employment, while inflation stays at the central bank’s target. The lower real natural rate will narrow the scope for the Reserve Bank of India (RBI) to use the usual tools of monetary policy to achieve price stability and growth outcomes. It could also jeopardize financial stability. In the event of a crisis like the one in 2008, the central bank will find it difficult to reduce interest rates beyond a point.
It is, therefore, imperative that the RBI put in place a macro-prudential framework that protects against this adverse demographic occurrence. One way to do this is to gradually push the economy towards greater capital mobility. The IMF posits, for instance, that countries with liberal capital accounts are able to counter the impact of adverse demographic trends on their real interest rates. This is because domestic interest rates in such countries are more influenced by global interest rates, which in turn are guided by the global savings-investment dynamics. India currently maintains some of the strictest restrictions on cross-border inflows and outflows of capital among emerging economies, and will stand to benefit from greater capital mobility.
Harsh Vora is an entrepreneur, investor and trader.
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