The Hindu Business Line : The interest rate paradox

In terms of the logic of demand and supply, an excess of the latter should see a decline in interest rates. This is not happening due to systemic deficiencies. On the contrary, taking the cue from the latest RBI action, banks are raising the lending and deposit rates. The price rise caused by costlier fuel prices cannot be controlled by tinkering with the interest rate. It can only be arrested by increasing supplies and curbing demand, both of which are difficult to do.

A terse Reserve Bank of India press release said: "On a review of current macroeconomic and overall monetary conditions, the Reserve Bank of India has decided to increase the reverse repo rate under the Liquidity Adjustment Facility (LAF) by 25 basis points to 5.75 per cent from 5.5 per cent with immediate effect. Simultaneously, the repo rate under the LAF, which continues to be linked to the reverse repo rate with a spread of 100 basis points, is also being increased by 25 basis points to 6.75 per cent from 6.5 per cent with immediate effect."

The market has interpreted the move as anti-inflationary and also a response to the hardening of rates in the US and Europe. The other monetary instruments available — the Bank Rate (BR) and the Cash Reserve Ratio — have been left unchanged. BR has ceased to be of any great importance as it is relevant only for specific transactions mentioned in the Reserve Bank of India Act. There was a half-baked and ill-advised attempt to revive it as a major instrument in the early 1990s but it was given up after the advent of new tools.

Whether the hike in the rates is going to make a dent in the situation remains to be seen. The system is marked by excess liquidity. In recent weeks, as much as Rs 60,000 crore was lodged with the central bank for reverse repos. There are practically no takers for the central bank money as seen from the absence of any transaction under the repo facility. The call money market has been quiet and the rate has been within the range set by the repo and the reverse repo rates.

Contradiction of sorts

In terms of the logic of demand and supply, an excess of the latter should see a decline in interest rates. It is not happening due to systemic deficiencies. On the contrary, taking the cue from the latest RBI action, banks are raising the lending and the deposit rates. They are also willing to take deposits for longer than five years.

However, the yield curve is somewhat flat at the long end compared with that at the short one. It appears to be a compromise worked out by banks balancing considerations of asset-liability management, on the one hand, and the cost of funds, on the other, keeping in view uncertainties on the future course of interest rates.

It is not clear why some banks are prepared to raise funds through certificates of deposit at, say, eight per cent, when others are willing to park their surplus liquidity with the RBI at the lower reverse repo rate with daily recycling.

Obviously, there is asymmetry in the money market whose primary role is to even out liquidity before banks approach the RBI either for borrowing or depositing surplus funds. The inter-bank term money market also lacks development.

US EXPERIENCE

In the classical case of transmission of the impulses of monetary policy, any change in rates gets passed on to the system through the commercial bank borrowings from the central bank. However, in the US,the central bank targets the Federal Funds Rate (FFR), the overnight borrowing rate in the money market, through its open market operations.

Its Discount Rate (DR) on bank borrowings is not operationally important. In fact, for long the DR was lower than FFR, defying logic but banks fought shy of accessing that window. The reason given then was that market knowledge of any bank approaching the Federal Reserve for funds would damage its reputation and also that the latter would ask uncomfortable questions on its balance-sheet and business.

Now the situation is different and the DR is higher than FFR. The Federal Reserve has been successful in maintaining the FFR at the desired level as seen from the time series on daily rates and their coefficient of variation available in the Web Site.

Aberration in India

In India there has been excess liquidity in recent years making it unnecessary for banks to borrow from the RBI. The shortage experienced in the first quarter of this calendar year was an aberration due to the cut-down in public expenditure resulting in government building up balances in the RBI and the outflow of funds caused by the redemption of the India Millennium Bonds. Now the situation has reversed. The Government has opened its expenditure tap and started resorting to the Ways and Means Advances of the RBI. Under the circumstances, the immediate impact of the rise in the rates is their hardening for government securities to be floated this year. It will aggravate the interest burden on public debt. What one is unable to understand is why banks should raise lending rates when there is surplus liquidity in the system and they are not borrowing from the central bank. There is no material difference to the situation consequent to the RBI raising its rates.

Supply and demand are like the two blades of a scissor. Often it may be difficult to say which one cuts. But still one may say that the price rise caused by the increase in fuel prices — both in the initial and the subsequent rounds of transmission — cannot be controlled by the interest rate movement. It can only be arrested by increasingthesupply and curbingdemand, both of which are difficult to attain.

Inflationary situation

One silver lining in the cloudy picture is the official recognition that there is an inflationary situation prevailing in the country despite the Wholesale Price Index (WPI) showing a rise of less than 5 per cent. The real situation is reflected not only in asset inflation but also in the steep price rise of basic necessities such as wheat and pulses. The Government should monitor the trends in the prices of essential goods and services rather than the WPI consisting of a hotchpotch of commodities many of which are of little interest to the common man. Attempts are being made to construct more meaningful price indices. It will take time. But in the meantime the Government can construct a Price Index for the Poor (PIP).

It can easily be done using the data already collected for the WPI and the weights therein for such items as rice, wheat, other coarse grains, pulses, sugar/gur, edible oil, fruits and vegetables. In other words, the weights can be reworked on a proportionate basis so that they add up to 100. The resulting total picture will be a better measure of the hardship of the common man than the existing consumer price indices, which come out after a time-lag too late for policy making. The merit of the WPI, forgetting its limitations, is that it is available in about a fortnight.

(The author is a former officer-in-charge of the Department of Economic Analysis and Policy, RBI.)

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