RBI should loosen monetary policy

Arvind Subramanian feels that India should not follow the trend of other Central Banks and lower interest rates since it runs a strong risk of stoking inflation. I will argue in this post that these concerns, especially that relating to the possibility of a fall in market confidence, may be over-played and there are strong reasons for relaxing the monetary policy.

With commodity and oil prices declining across the world and domestic inflation stabilizing and even falling, the time may have come to replace inflation with economic growth as the primary concern of monetary policy. The dramatic events in Wall Street and the recessionary fears enveloping both the US and European economies, will surely affect India and the emerging economies. At such times, high cost of capital can adversely impact the competitiveness and profitability of corporate India, with its heavy reliance on bank loans.

Here are a few reasons why interest rates should be lowered in the coming days.

1. Globally, interest rates are in the 2.5-5.5% range in Europe, 2.25-3.5% in North America, and 3.5-9% in Asia Pacific. It is in this context that interest rates in India, with a PLR of 13.75% and RBI repo rate of 9%, is surely on the higher side.

2. Though headline inflation in India is above 12%, it suffers from numerous distortions and is not an ideal guide for policy planning. A more reliable indicator would be the core inflation, which is in the 7% range. Using core inflation rate, the real interest rates in India, at 6-7%, is one of the highest among the major emerging economies.

3. In any case, the major reason for raising interest rates, inflation, appears to have stabilized and on its way down. The drivers behind this inflation - high global energy, foodgrain and commodity prices - are clearly on their way down in the face of a world-wide slowdown. Demand may still remain robust in China and India, but their export markets in US and Europe are already in or are staring at recessions. Oil has fallen from its high of $147.47 on July 11, 2008 to below $90, and is still falling.

4. All talk of the Indian financial system facing a crisis of confidence similar to that facing Wall Street and even European exchanges may be exaggerated. Given the deeply integrated nature of the global financial markets and the substantial Foreign Portfolio Investments (FPI) in emerging markets like India, it is undeniable that our equity and (less so) our debt markets will suffer from the sub-prime crisis. But unlike the US, India may at worst suffer from a liquidity problem but not a solvency crisis.

There are important differences. None of the major Indian financial institutions are significantly exposed to the mortgage backed derivatives and related securities. The balance sheets of the Indian banks and the macro-economic fundamentals of the economy remain strong.

Indian markets are more likely to be affected by way of foreign portfolio investors unwinding their positions, repatriating capital back home to shore up their beleaguered parents. In any case, a net outflow has been the characteristic of the domestic equity markets for a few months now. This has undoubtedly been the driver behind the falling share prices and to that extent has been a cause for concern, but has hardly devastated the economy as a whole.

5. The worst may be over and the Indian markets, and especially the major financial institutions, appear to have survived the scare without any major adverse long term fallouts. In fact, the PE multiples are now more closer to realistic and stable ranges.

6. As the large demand in the Liquidity Auction Facility (LAF) auctions and other repo windows of the RBI, and the lowering of the Cash Reserve Ratio (CRR) to 8.5% indicates, Indian financial institutions too are facing the credit squeeze. Given the uncertain environment (exemplified by the run on ICICI ATMs recently), the fears about counter party risks and weak economic expectations, the banks have become wary of lending. Bankers have become tight fisted and tightened lending standards, as they shore up the reserves, in order to weather the worst in these times of global turmoil. In the circumstances, the effective interest rates are much higher. The impact of this on the real economy will be significant and can no longer be ignored.

7. The broad money indicator M3, has been growing at an annual rate of 21% for the year-ending September 2008, against 20.6% for the same period last year. Though this is more than the stable range of 17-18%, it was in this higher range even when inflation was at 4-6% in 2007 and early this year. In fact, maybe partially due to the credit tightening measures, in the recent few weeks the M3 indicator has slowed down from 23-24% range in the middle of the year.

8. The recent depreciation of rupee can be attributed more to the massive unwinding of positions by foreign institutional investors, repatriating capital back home to shore up their beleaguered parents. The oil companies have also been purchasing dollar on a massive scale to meet their repayment obligations. Further, unlike previous instances, the RBI has not intervened much to halt the slide in rupee. Lowering of rates is not likely to have any effect on the exchange rate.

9. The high interest rates, at a time when Central Banks are loosening monetary policy, are likely to open up rupee carry trade opportunities. There will be an incentive to borrow at lower rates in a foreign currency and then invest in higher rate bearing Indian markets. The distortions spawned by such trade is well documented.

10. Finally, in any case inflation in India was not a demand-pull one but a cost push one, driven by global supply side constraints on commodities, energy and foodgrains. Any lowering of rates will do little to change or affect any of the factors that triggered and sustained inflation for the past six months.

Update 1
In a co-ordinated action, Central Banks across the world announced interest rate cuts to contain a crisis that is fast spiralling out of control. The Fed cut both the federal funds rate (to 1.5%) and discount rate by 50 basis points each. The ECB cut its benchmark rate to 3.75% from 4.25%, while the Central banks in Switzerland, Sweden, Britain, Canada, and China conducted similar moves. These actions makes the RBI loosening the monetary policy even more inevitable. In fact, RBI should not wait for the credit policy review to lower rates.