In a meeting with all bank chiefs last week, the Finance Minister requested them to soften interest rates, so as to maintain the current growth rates. The economic conditions present an interesting picture. While oil prices continue to move upwards, the inflation trends are more benign. Central Banks have to exercise their monetary policy levers by keeping a balance between the two, at times competing, concerns - growth and inflation. There are opinions both in favor and against easing the monetary policy. I will list out a few reasons as to why monetary policy should be eased.
In early 2007, with inflation threatening to touch 7% and beyond, and the Government facing coalition uncertainty, RBI was facing a difficult situation. The rising inflation in the early part of the year, coupled with the surge in foreign investments, both FDI and FPI, resulting in rising forex reserves raised major concerns within both the RBI and the Government. The RBI responded with a series of monetary tightening measures. The repo rate (at which RBI lends to banks) rose to 7.75% in three instalments, starting October 2006, the CRR went up to 7.5% in the same number of instalments from April 2007. It also raised the limit set on the amount of money that could be removed from the system by short-term (reverse repo) and long term (market stabilization) borrowing.
This monetary tightening has yielded results in the last six months, as WPI inflation has been brought down below 4%. With inflationary concerns allayed, the time has certainly come for growth concerns to take over. This means the RBI should ease the monetary controls and encourage investment. It is the time for aggressively cutting rates.
Monetary policy decisions are increasingly dependent on the global macroeconomic picture. Monetary policy autonomy has diminished to the extent that Central Banks have to factor in the fundamentals and the expectations in the global economy, atleast in the major economies of the world. It is in this context that India may be standing at a favorable position in the global growth cycle.
The US and Europe are easing their monetary policy out of compulsions arising from the sub-prime mortgage related credit squeeze and the imminent dangers of a recession. In contrast, India can afford to loosen monetary policy from a position of strength. A loose monetary policy is critical for continuing the rise in investment rates, at 35% of GDP, which is essential for sustaining the high 9-10% growth rates. In an increasingly integrated global economy, any US recession and low interest rates presents a great opportunity for India to sustain high economic growth without inflationary pressures.
A hard landing in the US and recession elsewhere in the developed world, will cause a fall in global aggregate demand, which will adversely affect the export-led growth economies. The high degree of integration between US and the Asian economies will only exacerbate any consequences of recession in the former, thereby triggering off a global slowdown. This will in turn dampen global oil, energy, food, and other commodity prices, and force down inflationary trends and lower import costs. Though these external shocks will definitely have an impact on our economic growth, India is uniquely positioned among the major economies to ride out this tide. Its low trade dependence, forming 23.5% of GDP, as compared to 36.6% for China and 72% for the ASEAN countries, and a large and fast growing domestic economy, ensures that the Indian economy will continue to remain largely decoupled from rest of the world. Its growing domestic savings rate, at 34% of GDP, and robust financial markets will only increase its ability to withstand external shocks.
There are no dangers of a credit flight or out of control inflation for the foreseeable future. A balanced play of the Impossible Trinity, by way of stable exchange rates and a gradual easing of capital mobility controls, will ensure that we are able to maintain interest rate autonomy.
I will list out a few reasons as to why monetary policy should be eased.
1. Low interest rates are critical for sustaining the rapidly increasing investment rate. It stood at 35% of GDP for 2006-07. Apart from reducing the cost of capital, it will also contribute towards sustaining the bull run in the equity markets.
2. Indian economic growth is extremely interest rate sensitive, given the large number of small and medium businesses, who depend heavily on bank credit. Further, the limitations imposed on accessing external borrowings, also increases the dependence on local bank credit.
3. A recession in the US and elsewhere will reduce consumption demand and hence lower aggregate demand, which in turn is likely to put downward pressure on import prices. A fall in global aggregate demand, is likely to also depress energy, commodity and foodgrain prices, thereby further lowering inflationary pressures.
4. The WPI is already at a very low 3.65% for the first week of December, and declining. Given that CPI follows the WPI, with a lag, the CPI is also set to fall in the coming weeks. Inflationary pressures are therefore well under control.
5. With declining rates elsewhere, prompted by the credit crunch, higher rates in India will open up carry trade like arbitrage opportunities, which are not necessarily desirable.
6. In the event of a recession in the US causing drop in FII inflows into emerging markets, a loose monetary policy could help provide the internal thrust to sustain and stabilize the stock markets.
7. In contrast, in the event of a capital flight into emerging markets, the low interest rates will reduce the incentives for financial market distortions that could encourage undesirable, hot money inflows.
8. By making rupee investments less attractive compared to the other currencies, low interest rates will reduce capital inflows and thereby control the exchange rate appreciation of rupee.
9. A low rate will leave the RBI with enough flexibility to manoeuvre without compromising on growth concerns, when the economy starts overheating, as it will frequently do.
10. The prevailing high interest rate regime had crowded in the overwhelming share of domestic savings into bank deposits, and crowded out the development of alternate investment avenues in the financial markets. The result is that such investments, including the equity markets (only 7% of population invest in shares), lack from adequate depth and breadth. A low rate regime could provide the opportunity for development of such market.
11. A lower rate will ease the demand for External Commercial Borrowings, which crossed $30 bn in 2007. India has emerged as the largest issued of foreign currency convertible bonds (FCCBs) in Asia, outside of Japan. While ECBs are to be welcomed as a source of investment alternatives, an over reliance on them, especially on certain categories, can have harmful medium and long term implications. We only need to look back at the East Asian currency crisis of 1997.
12. The low interest rates will give a filip to consumption growth as hire purchase and home loan markets will go up. The importance of the consumption driven growth multiplier for the economy is enormous.
More fundamentally, for far too long, interest rates in India have remained higher than the global average. It was understandable given the developing and closed nature of our economy, and high inflation rates. But these high rates had introduced many distortions into the economy. Now with economy opening up, financial markets getting integrated with the global markets, capital mobility restrictions being slowly eased, inflation coming under control despite the galloping oil prices, and global interest rates being eased, it is natural that our monetary policy be eased at the slightest opportunity.
As it is our interest rates are high enough to make the cost of capital for our corporates higher than their global competitors. At this stage of our economic growth, when we are stabilizing the high growth trajectory, it is important that we use every opportunity to lower the cost of capital for our corporates. Besides the immediate advantages, it also expedite the painless convergence of our economy with the global financial markets and also provide the Central Banks with greater flexibility to manoeuvre in times of inflationary pressures, economic downturns and financial crisis.
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