The Hindu Business Line : Higher interest rates can hurt investment prospects

Call rates shooting through the roof, banks selling off dollars, tax outflows, liquidity squeeze and inflation. How do all these phenomena mesh with one another? Dr D. K. Srivastava, Director of the Madras School of Economics, explains `how', through answers to a few questions from Business Line.

What do we start with?

Money supply. The year-on-year growth in money supply, as reported by the Reserve Bank of India (RBI) on March 23, is 22.1 per cent. The corresponding growth in money supply last year was 16.5 per cent. Recognising that such an upsurge in money supply growth would prove to be inflationary, the RBI has unfolded over the course of the last few months a number of measures to suck in some of this excess liquidity.

Measures such as?

Except for raising the bank rate, the RBI has deployed almost all other instruments in its armoury. During the period from December 2006 to February 2007, the RBI increased the cash reserve ratio (CRR) in instalments from 5 per cent to 6 per cent. It also raised the repo rate from 7.25 per cent to 7.5 per cent on January 31, 2007. It has also been operating an enhanced Market Stabilisation Scheme by auctioning dated securities as well as treasury bills so as to mop up liquidity.

How effective have these measures been?

The fallout of these sudden brakes on the growth in money supply is that interest rates have started rising. Throughout March, there has been a build up of interest rates. Commercial banks are advertising competitively for deposits at interest rates of 9.5 per cent or above. The prime-lending rate, which was in the range of 10.25 per cent to 10.75 per cent in March 2006, has jumped to about 12.5 per cent in March 2007.

And call rates?

The call money rates, which represent the short end of borrowing, also witnessed a sudden upsurge. On March 20, the call money rates zoomed to 22 per cent on average but some deals were reportedly in excess of even 50 per cent. It is remarkable that the rate was only 6-6.1 per cent in the beginning of March. In February 2007, the call money rates were between 3 per cent and 8.45 per cent.

Why the sudden spikes in call rates?

There is no doubt that some transitory factors have contributed to this inordinate increase in the call money rates. For instance, the middle of March represents the outer limit of advance tax payments. Such payments flow into the government's coffers. March tax payments are particularly large as the financial year draws to a close. Money goes out of circulation unless government departments also make corresponding payments. Thus money has been squeezed out precisely at the time when the banks are in rush to top up their cash reserves to meet the enhanced CRR targets.

What is the natural consequence?

The implication of higher cost of cash is that all demands go down. As demand for goods is constrained by the availability and cost of liquidity, inflation is supposed to be controlled. At the same time, as the demand for dollars goes down, the rupee firms up thereby hurting the export prospects. The higher interest rates have the capacity to seriously hurt investment prospects.

Can there be any collateral damage in this war against inflation?

Care has to be taken that the fight against inflation does not hurt our long-term growth prospects. Management of monetary policy requires that money supply is geared to grow at a predetermined target rate determined in consonance with the achievable growth in the economy. Sharp cyclical changes and sudden spikes must be avoided as they adversely affect expectations and become self-sustaining. It takes a long time to get back to the long-term growth path of the economy.

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