The Hindu Business Line : Will RBI Governor stay the course?

For the financial sector as much as for the common man, the level of interest rates and the stance of monetary policy are critical. With inflationary pressures rising and the current account gap widening, the conventional remedy seems to be for the RBI Governor to increase interest rates. But will a rate hike be appropriate given its possible adverse effects on growth and fiscal balance? Assessing the dilemma before the Governor, S. Venkitaramanan explains why this is not the right time to apply the rate squeeze.

ONE OF the issues that agitate the financial markets is the level of interest rates. The question many are asking now is whether the Reserve Bank of India Governor, Dr Y. V. Reddy, will or will not raise interest rates in his forthcoming Monetary Policy statement on October 25. Arguments are advanced both for and against. The protagonists of a rate rise argue that inflation is knocking at the door and a pre-emptive rate rise is called for.

The choices before the Governor are constrained by the possible impact of tightening on growth prospects for the economy. Much depends on the extent of the pass-through of the oil price increases to the consumer. This is muffled by the increasing competitive pressure as a result of globalisation and imports at lower prices. That higher inflation is a possible threat is accepted by all. The question is whether the RBI's actions, such as an interest rate rise, will affect externally imposed inflation.

For those connected with financial matters, the level of interest rates and the stance of monetary policy are critical. The cynic may say that the description does not concern only the financial sector but covers the entire public. No one can escape the influence of the monetary policy-maker, be it a change in interest rates, cash reserve ratios or exchange rate policy. The public naturally looks eagerly to the credit policy announcements of the RBI Governor.

Speculation on this front has been quite brisk, considering that the inflationary pressures are inching up and the current account gap is increasing. Both these issues call for the conventional remedy — higher interest rates. But the options before the Governor are not that simple. Will an increase in interest rates be appropriate given its possible adverse effects on growth and fiscal balance?

The debate on this issue has become rather interesting because the US Federal Reserve — usually the leader of global central banks — recently made yet another increase in interest rates. The Federal Reserve has, by and large, been accommodative in its monetary policy over the last few years, albeit accompanied by periodic adjustments in interest rates.

Whether India should follow the US lead depends on how we view our macro-economy. One critical variable is inflation. True, inflation has increased in India in respect of manufactured products (11.3 per cent), edible oils (8.5 per cent), cement, iron and steel.

But, overall, the Wholesale Price Index has gone up only by 3.5 per cent, according to the October 1 Weekly Statistical Statement issued by the RBI. This low inflation figure is discounted by critics as being influenced by the higher base of last year. The actual inflation numbers are not yet so forbidding as to call for a "brake" action by the central bank.

Critics of a benign interest rate policy point out that the guru of Indian economists, Dr C. Rangarajan himself, has warned of the risks of higher inflation. He is reported to have stated that the Government should be concerned about inflation if it reaches 8.5 per cent. While our current rates of inflation are still lower, critics point out that there are other signs of overheating in the economy. Housing activity is going on at a good pace and there is increased outlay on construction. But that is only to be expected in a growing economy, is it not?

Given these caveats, the need to keep inflationary pressures in check is obvious, but it is doubtful whether the conventional remedy of raising interest rates with a view to contracting demand is consistent with the objective of sustaining economic growth.

The Governor's dilemma is obvious. It is argued by advocates of rising interest rates that whether or not increases in interest rate contribute to lower inflation through decreased demand, they serve as signalling devices.

But the impact of such a signalling device is marginal when the economy is doing well and inflation is within tolerance limits. The time to apply the interest rate squeeze may not be now.

Yet another argument advanced by the inflation hawks is from the point of view of Balance of Payments considerations. The current account has been turning into a deficit recently. While this is reflective of the healthy expansion in import demand in the economy, it is also weakening the rupee. The current account deficit is, however, still within the critical 3-3.5 per cent of GDP and should not ring alarm bells. One doubts whether interest rate increases will themselves help in the adjustment of the current account deficit.

The data in the RBI's recent weekly statement disclose that credit growth is robust, a little bit too robust. But it is to be expected in a growing economy. Indeed, the pressures on the RBI and the bankers are all in the direction of increasing credit disbursements. It seems illogical to apply the interest rate weapon to cut or contract vibrant demand for credit when growth imperatives dictate otherwise.

The compulsions that may weigh on the RBI insofar as interest rate decisions are concerned are a mixed lot. The central banker, who is concerned about the health of the commercial banks, will also have to factor in the likely hit on the value of the considerable amount of government securities held by the banking system in case interest rates are raised.

True, there has to be a distance between the central banker in his capacity as monetary authority and his occupying the position of custodian of bank's financial health.

Whatever the Chinese walls in the central bank's working, this consideration about the bank's bottom-line may also have a part to play in deciding on a "benign" interest rate policy and not raising the rate now.

Above all, the Governor has to keep in mind that the economy is just getting out of the vicious cycle of low investment and low growth. To disturb the behavioural patterns of investors in the market with an interest rate rise is, to my mind, an unnecessary intervention and may well be unproductive.

Nor is it sure that it will yield the results expected of such increases on the inflation front, especially where inflationary pressures reflect global supply patterns, which are unaffected by our interest rates. Above all, it is illogical for the apex bank to apply both the interest rate brake and demand acceleration of credit supply to the economy at the same time. On exchange rate policies, the RBI seems to be set on a course of action which has yielded good results over time.

True, at present, the rupee is falling. But that is not all bad. At any rate, Indian exporters are cheering all the way to the bank and Indian manufacturers are none too disgruntled as long as the fall is within limits.

The higher current account deficit does have a part to play in determining the depreciation of the rupee. It is also important to calibrate the interest rate response in respect of the rates offered on NRI deposits — if such deposits still figure in our BoP.

Insofar as exchange rate policy is concerned, the RBI has to make a measured exercise taking into account the need to maintain export competitiveness and limit the inflationary consequences of a cheaper rupee.

One has also to consider the implications of a falling rupee on the attractiveness of India's capital markets for overseas portfolio investors. If on top of the volatility of the Sensex the portfolio investor has to calculate the impact of a decline in the rupee, it may be a counter-incentive to invest in India. It is natural for the RBI to keep in mind the adverse implications of the falling rupee on the portfolio flows — which are, to some extent, critical for both BoP reasons and market stability. While these reasons may not be spelt out in precise terms, I am sure they figure in the Governor's thought process.

Finally, the dilemma before the Governor in regard to interest rate policies is accentuated because of the heavy borrowing programme of the Government. A rise in interest rate has doubtless an adverse effect on fiscal balance. The mixture of roles as debt manager and monetary authority is apt to lead to a conflict of interests. But the RBI cannot ignore the adverse fiscal effects of rising interest rates.

Even if the central bank sheds its role as debt manager for the government, consultation with the latter is obviously indicated. The RBI can be independent of, but not irresponsible and unresponsive to overall macroeconomic policy concerns.

To my mind, the portents are that Governor Reddy will stay the course with the benign interest rate regime and not try to rock the boat, keeping in view the macroeconomic considerations. The rupee will most obviously float downwards, but within limits, dictated by the RBI's interventions. All in all, I see prospects of a mixture, as before, in the Governor's October 25 mini-spectacle.

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