Thursday, October 8, 2009

RBI should not raise interest rates

The voices in favor of raising interest rates appears to be growing in strength, with RBI Governor himself repeatedly expressing concerns about the rising inflationary concerns. However, in view of the underlying economic factors driving demand and the need for monetary policy to manage inflation while stabilizing economic growth, simplistic inflation rate driven monetary policy responses may not yield results.

The greater challenge for the RBI at this point in time would be to manage the exit from its expansionary credit policies of recent months using the non-interest rate instruments of monetary policy. Any inflation driven changes in interest rates would be a throwback to the mistakes of a "single-minded inflation targetting or price-stability approaches to the conduct of monetary policy over the past decade that led to financial imbalances and the crisis".

Here are five reasons too keep rates unchanged for the foreseeable future.

1. The inflationary signals conveyed by the deeply flawed weeekly and monthly indices cannot be the basis for so important a policy decision as interest rate increases. Monetary policy can be deployed in controlling inflationary pressures arising from increase in money supply. It cannot be effective against supply-side constraints induced cost-push inflation.

The inflationary pressures today resembles a cost-push inflation scenario. Global commodity prices - foodgrains and metals - are on their way up driven by many factors, including the rapid demand recovery in China and other emerging economies.

Domestically, the supply side constraints that have contributed to the recent increases in foodgrain prices may get exacerbated in the months ahead, especially in view of the poor monsoon. Prices of commodities like sugar are likely to go up in the next couple of years, irrespective of whatever happens on the monetary policy front. Further, our increasing reliance on oil, pulses, sugar and wheat imports, and their price volatility in the global markets, will also add to the inflationary pressures.

It is important to plan well in advance to ease supply side constraints with increased imports, larger buffer stocks, and longer-term efforts to increase agricultural output and acreage. These policies will have to be supplemented with more effective deployment of the Public Distribution System (PDS), so as to cushion the poor and most vulnerable from adverse shocks arising from foodgrain price increases. In fact, events over the last eighteen months and its impact on food prices, only adds weight to the continued relevance of food safety nets like the PDS. In fact, they carry much greater importance than monetary policy instruments in combating inflationary pressures.

2. The green shoots of recovery across the world is mixed and there is great uncertainty about the economic prospects. In the circumstances, the global demand for our exports will remain weak and at best subdued. Domestic demand will be the engine of growth required to sustain the high growth rates in the next couple of years. Interest rates and cost of capital are one of the fundamental determinants of business investment decisions. There is enough example from across the world, most notably Japan in the later part of the nineties and RBI itself in 2007-08, when interest rates were raised too early and too fast nipping off nascent signs of recovery.

3. Cheap credit supply is critical to sustaining the green shoots of economic recovery. Recently released data on the debt servicing burdens of Indian companies, reveals a high debt-to-equity ratios for many Indian companies, especially in the construction and infrastructure sectors, which inflates their debt servicing ratios. Any increase in interest rates will only increase their debt servicing burdens and shrink their bottomlines and thereby squeeze business growth and investments.

4. A strenthening rupee will only add to the pressure on the government to keep rates low.

Higher interest rates, especially when rates elsewhere appears set to remain unchanged in the medium term, will only encourage distortionary capital inflows like dollar carry trade (borrow cheap in dollar elsewhere and invest in higher return rupee assets) which will lead to further rupee appreciation against the dollar. A manifestation of this carry trade is the rising FII inflows and the spectacular rebound in equity markets. This is already Exchange rate management will become increasingly difficult.

In the context of the strengthening rupee, any open market interventions by the RBI to prevent appreciation is likely to rebound badly and result in increased money supply (arising from rupee infusions to purchase dollars and the need to sterilize it by selling securities) and upward pressure on interest rates.

5. There is a difference between liquidity availability and actual credit off-take by individuals and businesses. The RBI's expansionary policies of the past few months have reflated the liquidity positions of banks and made ample liquidity available. However, the widespread uncertainty about counter-party risks coupled with the economic slowdown and consequent dip in credit demand, have had the effect of keeping the liquidity taps of banking system relatively dry. As reflected in the higher than required investments in the safety of government securities, much of this liquidity has been doing round-trips of bank reserves and RBIs reverse repo auction window.

The result has been that aggregate credit growth at 15% is well below the RBI's target of 20%, and last year's 26% growth rate. Further, this subdued credit expansion contains a substantial contribution from government borrowings and fiscal expansion induced credit off-take. In other words, the liquidity overhang in the banking sector has not found its way into the real economy.

The RBI can exit from its liquidity expansions, at an appropriate time, by using other credit policy instruments like raising the reserve and liquidity ratios - CRR and SLR. This would help squeeze out the liquidity excesses that can stoke off inflationary pressures.

Update 1
Instead of obsessing with inflation, RBI should also be keeping a tab on the massive liquidity findings it way into the financial markets and stoking off bubbles there. With credit flow into businesses and consumption remaining subdued, RBI should be careful about credit getting mis-allocated into the financial asset markets. How much of the excessive liquidity in the banking system has contributed to the latest stock market rise?

And as Tim Duy and James Kwak write, this real concern can be alleviated with more effective and vigilant regulation. In other words, lower rates and effective regulation, can achieve both results - ensure that "green shoots" are not nipped off by the increase in cost of capital and asset bubbles do not get blown up by the excess reserves floating in the banking system.

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