Why RBI governor is right in keeping a tight leash on interest rates

Recently RBI has come in for criticism, mainly from business interests, for keeping interest rates high. A major plank of the attack is that high interest rates are crippling economic growth and this is not to the liking of the government which has touted economic growth, measured in percentage rates for GDP, as the sole measure of development for over two decades.

Countering complaints, RBI governor Duvvuri Subbarao often stated that the fight against inflation, presumably consumer inflation, leaves no room for interest rate reduction which would lead to increase in money supply. It now appears that Subbarao will not get an extension of his term as RBI chief.

Few can deny the steep increases in consumer prices, in particular food in the recent years. Official inflation statistics hardly bear relation to the actual price increases consumers experience while shopping. The conventional wisdom that increases in money supply leads to inflation has been almost completely ignored by the government in the recent years which has happily run up huge fiscal deficits, ostensibly to promote economic growth. It is a different story that the resulting increase in government resources have led to unprecedented corruption and appropriation by insiders.

According to Federal Reserve of St Louis (US), aggregate money supply, the M3 measure of monetary aggregates, almost quadrupled in India from Rs 21.4 trillion in 2004 to Rs 80.3 trillion in 2012. To provide perspective, money supply in 1991 when economic reforms were launched in the country was Rs 3 trillion. In other words, money supply has increased about 27 times during the era of reforms.

The increase in money supply is explained by several factors – foreign inflows, deficit financing, and bank lending. Obviously this translates into high inflation, not just for assets (mainly shares and real estate), but all round including food essentials and things like clothing and construction materials. Apparently referring to the volume of money supply in the economy and high inflation, Subbarao recently stated that there is no room for monetary easing.

RBI reduced short-term lending rate from 8 per cent in 2008 to the current level of 7.25 per cent. Further reductions in interest will lead to higher money supply and encourage bank lending. This will probably translate into higher consumer inflation which affects the everyday lives of large sections of the people, in particular the poor. Demands for cutting interest rates are made on the reasoning that it will encourage borrowing and spending, which in turn will contribute to economic growth. This mono-dimensional approach to economic growth relied on by the government fails to consider other – and equally important – factors.

Inflation is one issue that must figure in the discourse on interest rates and economic growth. Another issue that hardly receives attention in the current debate is the consequence low rates will have on savings and senior citizens who rely on interest income for their livelihood. A large section of retirees, currently past working age, do not receive any pension and depend on the interest on their savings. This segment is vulnerable and will be subject to the double-whammy of lower income and higher living costs due to inflation.

Economic growth

A third issue is moral hazard arising from liberal lending policies in a low interest regime. Over the last several years, the government has used its control of banks to expand credit on the calculation that this will contribute to economic growth. According to recent reports bad loans represent over 10 per cent of the total advances made by banks in India, and bulk of this comes from public sector banks. Political use of bank funds which started on a smaller scale with the loan melas of the 1980s has morphed into large-scale lending for business, real estate and durable assets.

Kingfisher Airlines and the real estate developer DLF are high-profile examples of the irresponsible lending policies. Lanco, a politically-connected business group with debt of over Rs 33,000 crore, is reported to be ‘restructuring’ its debt. Against this background, a government that is already running huge deficits speaks glibly of ‘injecting’ several thousand crores of rupees into government-owned banks. Sadly, there is little public awareness or debate on these issues.

Finally and most importantly, the question is about the size and importance of the financial sector in the economy. Enormous growth in money supply and trade in shares by a greater number of people have turned the focus on the financial side. Banks which are the main traffickers of money have emerged powerful. In the process, the real economy of goods and services has been sidelined. Arguably, this is an international phenomenon – one that Kevin Phillips characterised as the ‘financialisation’ of America. The present Indian government, headed by a former central bank governor, is understandably adept at pulling monetary and fiscal levers and has strengthened the trend of financialisation in India.

There is a need to realign the financial economy with the real economy of goods and services produced by the honest labour of people, as distinguished from profits made from financial transactions such as lending or trade in shares.

Any reduction in interest rates is also likely to contribute to increased share trading and fuel financial speculation through margin loans.

Interest rates are a loaded pack and needs careful handling and deliberation. Importantly, it would be a positive step forward if the Reserve Bank of India and the ministry of finance begin to make greater disclosures about their policies and actions and, more importantly, reasons underpinning the policies. The cloak of secrecy that surrounds the financial system is opposed to the values of transparency and accountability that are essential to democracy. The need for openness has never been greater.

(The writer is an assistant professor at University of Ottawa, Canada)