Saturday, August 1, 2009

Lower interest rates and emerging economies

The RBI has left interest rates in tact in its latest quarterly monetary policy review. The ongoing economic recession and loose monetary policy followed by all the major economies, coupled with low domestic inflation, are reason enough for the RBI to keep interest rates at the lowest possible value. The specific Indian domestic situation apart, here are some more reasons for developing economies in general to keep interest rates low.

1. It lowers the cost of capital for businesses and thereby increases their competitiveness.

2. It facilitates the re-emergence of the vibrant market in consumer and housing mortgage loans that in turn can boost domestic consumption and aggregate demand.

3. It also reduces the attraction for hot money inflows to take advantage of the interest rate arbitrage opportunities (actually, the depreciating local currency adds to the attraction). Higher rates draw in external capital, which in turn works to put upward pressure on the domestic currency, reduce export competitiveness, and force Central Banks to intervene to manipulate the forex markets. Such manipulations by aggressive purchases of dollar generates several distortions. If not sterilized, it increases the money supply (and thereby stoke inflationary pressures) and if sterilized, it increases the interest burden.

4. Moderate inflation is desirable, especially in developing economies. It incentivizes consumption over savings, reduces the real debt burden on borrowing businesses, allocates and ensures more efficient utilization of resources, and is an indication of an economy approaching its potential output frontier. Low interest rates, especially now, leaves open the window for moderate inflation.

5. Lower rates also have more profound implications for the entire financial system. It weans savers away from plain vanilla bank deposits and makes equities and other assets more attractive as investments. Greater liquidity increases their depth and breadth of their financial markets and makes them more competitive. In fact, the present global financial market environment offers an excellent opportunity for the rapid development of mature financial markets in emerging economies.

6. It minimizes the impact of government debts and lowers the cost of capital for resources strapped governments.

7. Lower interest rates will also make savings relatively less attractive and encourages consumers to increase their spending. This is extremely important given the economic slowdown, which demands that everyone chip in with their contribution towards boosting aggregate demand.

8. As mentioned earlier, the hot money inflows due (partially) to the higher interest rates puts upward pressure on the domestic currencies and forces Central Banks to intervene. As Simon Johnson argues, in order to avoid the unpleasant consequences of all this, emerging economy governments may find the retrograde step of capital controls on both capital coming in and going out attractive.

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