New Delhi: Real interest rates in India could decline by more than 150 basis points between 2020 and 2030, the International Monetary Fund has said in a new working paper titled Demographics and Interest Rates in Asia. This, in a week when the Reserve Bank of India (RBI) decided to hike its key policy rate by 25 bps to 6.50%—the second such move since June. One basis point is one-hundredth of a percentage point.
According to the IMF working paper, a relatively less open economy like India with falling young population (0-15 years) due to declining fertility rate, real interest rate could decline by more than 150 basis points in the next decade between 2020-30.
The paper holds that three factors impact interest rates in a country: the degree of openness, the state of ageing, and the speed of ageing. For countries that are fully open, demographic factors do not have a direct effect on domestic long-term interest rates as they are driven by global savings and investment.
For countries post their demographic dividend such as South Korea and Thailand, rising old age dependency is expected to depress interest rates. For countries that are at an early stage of their demographic dividend such as India and the Philippines, falling youth dependency (0-15 years) is projected to reduce interest rates. Finally, as the speed of aging slows in some cases, the aging speed effect will temper the decline in interest rates.
This implies that when the youth dependency rate rises initially in the age cycle of a country, investment demand can increase, while saving declines. Then, as the age distribution shifts toward the middle age, saving increases and investment demand declines, thereby lowering interest rates. Eventually, an increase in the elderly dependency rate would cause saving to fall, surpassing investment demand decline, thereby raising interest rates.
For countries like India as the youth dependency declines, the working age population saves more pushing down interest rates. “Declining youth dependency, especially in relatively young countries such as India, Indonesia, and the Philippines whose fertility rates are projected to decline, is expected to decrease interest rates. On the other hand, aging speed is projected to increase in currently young countries such as India and Malaysia, driving down their interest rates," IMF said.
IMF said adverse demographic trends, by reducing long-term interest rates, have an impact on both the conduct and transmission of the monetary policy as well as on financial stability. “For the former, the ability of a central bank to successfully attain its objective of price stability and keep output at its potential becomes more limited in an environment of low and declining natural rates of interest. This effectively squeezes their monetary policy space," it added.
RBI’s six-member monetary policy committee on Wednesday voted 5-1 to raise policy rates by 25 basis points to 6.5%. This is the first time since October 2013 that RBI has raised rates in consecutive meetings of its rate-setting panel. It raised interest rates by 25 basis points in its June meeting.
In an update to its World Economic Outlook (WEO) released last month, IMF trimmed India’s growth projection for 2018-19 by 10 basis points to 7.3%, citing negative effects of higher crude oil prices on domestic demand and faster-than-anticipated monetary policy tightening due to higher-than expected inflation.