RBI holds the key

If RBI keeps interest rates unchanged in its next policy review on July 30, it will deepen the economic crisis.

The Indian economy is balanced on the edge of a precipice. A three year diet of high interests in the midst of a deepening global recession and slowing employment growth at home, has brought the industry close to death. Since October 2010 Industrial growth has averaged 0.95 per cent for the 20 months. Between October 2009 and July 2010 it had grown by over 12 per cent. Within industry, it is the most modern sectors, those whose growth potential is highest, that have been hardest hit: automobiles at minus 9 per cent;  consumer durables minus 10.4 per cent, and capital goods minus 15.2 per cent.

Non-agricultural employment growth at 0.2 per cent. In any other country this would have been sufficient to bring a government down. Here these grim figures have caused barely a ripple in our ruling class.   

The decline has spread to the financial sector. Profits of even the private banks, which do not have to meet various priority lending requirements, have slumped. The proportion of bad loans is rising. But the most serious crisis is developing in the balance of payments. Foreign investors – both FIIs and NRIs -- are pulling their money out of India because they have lost faith in its future. As a result the rupee has lost more than 10 per cent of its value in the past three months.

According to the RBI the crisis is only a reflection of  the deepening global recession which has severely hurt exports and increased the current account deficit to a hitherto unscaled 6.7 per cent of GDP in October to December 2012. It  has also ascribed much of the depreciation in June  to the US’ decision to end of its  fiscal stimulus programme. This, it claims, has increased the lure of the dollar.

But these are attempts to shift blame and not explanations. The global recession has been deepening gradually for the past five years, so the  fall of the rupee should also have been  gradual. But a close look shows that the rupee had held firm through three years of recession, till July 2011 at Rs 43-44 to the dollar. All the loss of value has taken place in the past two years. What is more, it has taken place in two short bursts, that have both followed  RBI announcements that have taken investors by surprise and eroded their confidence in the soundness of India’s monetary policy.

The first rapid slide of the rupee  began immediately after the RBI raised interest rates in its July 2011 first quarter policy review. The decision was perverse, to say the least, for by then industrial growth was in a tailspin and no amount of self deception could hide the fact that the Indian economy was sliding into a recession. Its action  broke the confidence of investors all over the world in the Manmohan Singh government’s ability to manage the Indian economy. Between July and November 2011 the rupee lost 18 per cent of its value.

Lowering interest rates

The second sharp fall in the value of the rupee, of 11.5 per cent has also taken place in a 63 day period between May 5 and July 8. The dates are not fortuitous: the slide began on the first working day after the RBI disappointed both domestic and foreign investors on May 2 by cutting repo rates by only a quarter of a percent. It halted, momentarily, on July 8 because this was the first working day after the government doubled the price of natural gas and raise the price of diesel. Markets took this as a signal that the RBI would respond by lowering interest rates. But the RBI remained impervious to change for, a day after the release of the grim data on industrial production, the governor of the Reserve Bank, D Subba Rao, announced that since consumer price inflation was still running at 9.97 per cent he would continue to give priority to containing inflation over reviving growth. Predictably his statement touched off another exodus of foreign money. Within two working days this forced him to raise a key interbank lending rate by a full 2 per cent, and impose physical controls on lending in a bid to stem the fall. This has now begun to harden interest rates across the board – exactly the opposite of what the economy needs.

One does not, therefore, have to be an economist to conclude that the cripplingly high interest rates that the Reserve Bank has imposed upon the country ever since March 2010 lie at the root of both the relentless decline in the economy and the growing foreign exchange crisis it now faces. In other countries that made the same mistake better sense has begun to prevail at last. The Japanese economy, for instance, has revived after premier Shinzo Abe broke with monetarism, brought interest rates down sharply and allowed the yen to depreciate against other currencies. The IMF has also changed its tune.

Today the government has run out of options. If it keeps interest rates unchanged in its next policy review on July 30, it will deepen the loss of confidence in the economy and the rush to pull money out of it. If it tries to defend the rupee with still more controls, it will only worsen the crash that will follow. These controls can at best buy time for policy reforms that will restore confidence in the economy.

The one, and only, policy change that can do this is a sharp cut – 2 per cent or more -- in interest rates. This will shift some money from bank deposits to the share market and push up share prices on a sustainable basis. That will immediately stop FII’s from withdrawing their funds and ease the pressure on the rupee. The rise in consumer spending and investment that will follow a short while later will strengthen confidence further. 

The RBI can minimise the risk further by limiting private borrowing abroad and further curbing the import of gold till  the economy gathers steam once more. If it still baulks at lowering the interest, the Central government must find a way of making it change its mind. For, we have run out of time.