RBI must embrace rate cuts

On April, 2016, the Reserve Bank of India (RBI) announced its first Monetary Policy Review for the financial year 2016-17. While continuing the trend of reducing interest rates, the repo rate (interest rate at which banks borrow from the RBI) has been reduced from 6.75% to 6.50% and cash reserve ratio (CRR) has been kept intact at 4.0%.

Although by using some other measures – like reduction in marginal standing facility (MSF) rate by 75 basis points to 7% – the RBI has tried to improve liquidity in the economy, the market which had expected a much bigger reduction in interest rates, showed its displeasure by a sharp decline in the share prices. The market experts believed that the repo rate would be brought down by at least half percent.

It may be noted that after 2010, the RBI started increasing interest rates due to high rate of inflation. The repo rate, which was only 5% in 2010, increased to 8.5% by 2012. Later, the RBI started reducing the policy rate and it now stands at 6.5%. Nevertheless, the RBI has been moving cautiously and has actually followed the 'wait and watch' principle. It seems that the body is still not confident about the stability of prices and a high growth trajectory in the near future.

It appears that the RBI is apprehending a fresh spurt of inflation due to implementation of 7th Pay Commission and One Rank One Pension (OROP), apart from monsoon uncertainties. Rating agencies like Moody's are also airing similar concerns apart from fearing depreciation of rupee. However, their apprehensions seem to be unfounded for more than one reason.

Firstly, after a long time, weather forecasters are seemingly in consensus that this year the monsoon would be normal and India is likely to witness a bumper crop. Secondly, the rupee has been growing consistently in the last more than one month, primarily due to consistently improving condition in balance of payment deficit on current account (CAD) and also a persistent surplus in balance of payment on capital account. There does not seem to be any reason for commodity prices to move upward in the near future.

According to the Chief Economic Advisor Arvind Subramanian, India's economy has been passing through deep deflationary situation. Though growth is picking up, wholesale prices of commodities, including metals and crude, have been coming down. An important indicator of inflation, called the GDP deflator, is clearly indicating at deflationary situation, due to which GDP growth in monetary terms is slower than real GDP growth. This situation, though rare, causes not only shortfall in revenue but incentive to increase production also gets adversely affected.

The situation is no different in other parts of the globe. To deal with the problem of economic slowdown, the US, the European nations, Japan and many other countries have reduced their interest rates to near zero level. The US has been following a most unconventional monetary policy in the name and style of ‘quantitative easing.’

Courageous monetary policy

Today, when retail inflation is less than 5% and wholesale inflation has been in negative zone for nearly 15 months, there is an almost certainty about normal monsoon with GDP growth expected to be nearly 8%. With hardly any danger to the stability of rupee, the RBI could have easily gone for improving the liquidity position in the country, satisfying the thirst of the market and bringing improvement.

RBI Governor Raghuram Rajan has been time and again pleading for transmission of lower interest rates to the borrowers. No doubt, this move by the banks would improve the demand for credit and increase much needed liquidity in the system. However, by suggesting this, the RBI cannot absolve itself of its duty to reduce interest rates significantly, which is an urgent need to tackle the problem of deflation in the economy. There is no doubt that once policy interest rates are reduced, demand for credit to build roads, bridges, airports and other infrastructure would go up; and consumer demand will also shoot up.

It is notable that in the past, whenever interest rates were lower, growth was boosted. For the first time, when the economy could surpass the hurdle of low growth rates (what used to be called ‘Hindu Rate of Growth’), it was basically due to low interest rate regime. During NDA-I, under then prime minister A B Vajpayee, lower interest rates gave a fillip to development.

Rate of growth of industrial development, which was hardly 4.1% in 1998-99, reached 8.4% by 2004-05. The country witnessed a fast expansion of road network and other infrastructure under Public Private Partnership (PPP) projects. The housing sector saw a big boost due to huge demand.

Perhaps, a major factor which helped  development was low interest rates. For instance, at a rate of interest of 8%, an equated monthly instalment (EMI) on 20 years of housing loan of 10 lakh was hardly Rs 8,360, whereas for a housing loan of the same maturity at 10% rate of interest, one needs to shell out Rs 9,650 as EMI. Expectedly, lower rate of interest led to expansion of demand for cars and other automobiles, consumer durables, housing etc, apart from encouraging entrepreneurs to expand their businesses.

During UPA-II, high rate of inflation and resulting high interest rates, led to downfall in economic activity. Rate of capital formation, which had reached 37% at one point of time, nosedived to 31%. Therefore, dispelling unfounded fears, the RBI should reduce interest rates, especially the repo rate to at least 6% and usher in an era of lower interest rates to boost growth, more so when the economic situation is ripe for the same.

(The writer is Associate Professor, PGDAV College, University of Delhi)