RBI policy today: hoping for a reduction in interest rate

Within the Indian economy, potential stability is determined by various equilibrium levels of the tri-junction of income-expenditure balances, money market balances, and the country’s balance of payments (BoP) or trade balances (the difference between earnings from net exports and spending on imports). The concerned equilibrium varies from changing and evolving economic situations, necessitating adjustments of any single or more components, constituting the economic equilibrium.

Nevertheless, the BoP component is particularly imperative while observing and appraising the full effects of international interactions; alternatively, evaluating the open economy macroeconomic policies of a country, which determines an explicit working out of the dynamics of international finance. It is expected that the nominal interest rate of the country could be pared down by about 0.25% by the Reserve Bank of India (RBI) when it announces the new policy on December 7. The objective would be for a potential expediency of the economy, currently grappling with the aftermath of demonetisation.  

The monetary policy – managing the flow of money – and fiscal policy – entailing government expenditures and earnings – jointly determines the net economic policy and position at any given point in time. Monetary policy is substantially the forte of the RBI, while fiscal policy is the preserve of the Union Finance Ministry, complemented by the finance ministries of the state governments. Each has its clearly specified jurisdiction.
The merits of respective situations necessitates the intervention of either sector independently or both together. At times, frictions could arise, but that is usually resolved or prevented altogether through a mechanism. Deciding the level of the nominal interest rate of the country is the exclusive domain of the RBI, supervised by a Monetary Policy Review committee. Given other inherent strengths of the Indian economy, at present, the lowering of the interest rate – commonly known as the “repo rate” — would be undertaken with an aim to boost spending and encourage investment, currently relatively sullen from the effect of demonetisation.

The negation of the Rs 500 and Rs 1,000 denomination legal tender has, in effect, taken off 86% of the liquidity money in the circulation in the economy. While new legal tenders of Rs 500 and Rs 2,000 denomination have started to reach banks across the country, its volume is not yet adequate to achieve the required levels of liquid cash, obligatory for the approximately $2 trillion valued net Indian economy.

Notwithstanding the understandable criticism levelled at the Central government for apparent unpreparedness in making arrangements for relatively smooth flow of money of new legal tenders, steps are being taken by monetary and fiscal authorities to lessen the ordeals of citizens before normalcy is fully restored; the reduction of the country’s borrowing interest rate would be a notable step towards that purpose.

Lowering the nominal interest rates would lead to a potential increase in the flow of money in the economy; the scope for borrowing for investment purposes would be relatively enhanced. The flow of liquidity money would spike upwards than before. With lower interest rates, the position of equilibrium between the money balances and income-expenditure would shift to a position which would reflect a comparative increase in the flow of money and spark off possibilities for greater output in the economy: producers would bolster their production activities with a lower payable interest rate against borrowed financial capital for economic activities. Nevertheless, this has its admonitory effects as well.

A greater flow of and availability of financial capital at lower interest rates and high capital mobility would lead to greater import expenditures than export earnings and a proclivity for further acquisition of foreign financial assets by Indian citizens than a similarly discernible trend in the reverse direction. It would create a greater widening of the trade balance or BoP deficit than it is at present.

But, as the prevailing trade balance of the country is tentatively -0.9% of the GDP (market value of all goods and services produced within a nation’s borders during a given period of time), the necessity to cushion its effects could be relatively relaxed for the time being, notwithstanding the keen observation necessary to prevent undue accumulation of negative counting of trade balance record.

Pressure on rupee
Consequentially, there would be palpable pressure on the rupee to depreciate further. Because the country has a floating exchange rate and not a fixed exchange rate, the RBI would not necessarily sterilise the pressure by selling foreign exchange reserves into the market, thereby reducing the quantity of money in the market, and thwarting depreciation. The country’s exchange rate would rise, causing the rupee to depreciate marginally for the time being.

But, it would encourage more Indian exports in the international market causing the income-expenditure position to increase and also propel the BoP deficit to narrow down again.

The final outcome of the expansionary monetary policy action, if implemented appropriately, could ultimately lead to a rise in the equilibrium level of the real income; the balance among the income-expenditure, money market and BoP would reflect a new, increased, level. The economy would benefit on the whole.  

The RBI authorities, led by Governor Urjit Patel, would also be helped by the encouraging levels of inflation – general price level — in the country: it is 4.2%. That is low enough to fend off possible public grudges during the course of the monetary expansionary exercise which could push inflation relatively northward during the phase of greater demand for commodities when liquidity money flow increases and the production flow is yet to balance the money flow.  

Foreign Direct Investment (FDI) flow into the Indian economy has crossed $300 billion, establishing the country as a reliable destination for organised foreign investment. Additionally, the country’s internal economy has acquired a notable measure of vibrancy and optimisation capability.

Although labour-intensive sectors, in particular, as also the services sector, to an extent, are in a quandary in the aftermath of demonetisation, there are indicators that it is a fleeting phenomenon. A relative deduction of country’s nominal interest rate would determine relative economic amelioration, provided it is carried out with care and efficacy.  
(The writer is an analyst on international finance)