MAVERICK VIEW. Beware the rate cut brigade

The formulation of monetary policy always involves hard choices, though on occasions the choices are unusually hard. The second monetary policy review of 2015-16 on June 2 is a challenge to the renowned skills of Governor Raghuram Rajan. While the Reserve Bank of India (RBI) will no doubt take a well-informed decision, it would perhaps be of use to the public at large to be aware of some of the dilemmas it faces.

Influential policymakers and opinion-makers have strongly advocated a relaxation of monetary policy. Finance Minister Arun Jaitley is explicit about what he wants, namely a reduction in the policy repo interest rate, though he correctly states that this matter is in the domain of the RBI.

The Union Minister of State for Finance Jayant Sinha and Chief Economic Adviser Arvind Subramanian echo similar views. Former Finance Minister Yashwant Sinha has unequivocally advocated that there should be a 1.5-2.0 percentage point reduction in the repo rate. The industry lobby is of the view that a reduction in repo rate is a sine qua non for recovery of industrial output; many prominent economists and editorials in the financial press have echoed similar viewpoints.

As the RBI focuses on inflation control, advocates of policy relaxation argue that with the year-on-year Consumer Price Index (CPI) inflation rate abating to 4.9 per cent in April 2015 and the Wholesale Price Index (WPI) in negative territory of 2.65 per cent, and food inflation moderating, there is no case for postponing a repo rate cut. It is argued that with both deposit and credit expansion being unusually low in 2014-15, monetary policy easing is mandatory to facilitate a 7.5-8 per cent growth rate in 2015-16. It is further emphasised that with international financial institutions predicting that India will be the fastest growing country in the world in 2015-16, there is a strong case for reducing policy interest rates.

In recent times, the inflow of foreign funds has been declining and the rupee exchange rate shows a downward trend against the US dollar. The six country trade weighted real effective exchange rate shows a large appreciation of 25 per cent as of April 2015. Indian exports have slowed down significantly. With the revival of domestic activity, imports are bound to pick up and the current account deficit (CAD) is likely to widen. With the possibility of the CAD widening, any reduction in policy interest rate now could require a substantial reversal of interest rates in the near future.

Although the inflation rate has come down, there are a number of concerns. First, the rate is well above the global norm. Secondly, an adverse monsoon could result in an upsurge of food prices. Thirdly, official Indian price indices have all along been lower than what is actually reflected in the marketplace. This phenomenon is not unique to India but given the large tracts of poverty in India, any increase in inflation has a disproportionate adverse impact on the masses. Reflecting the popular perception, an opinion poll conducted by Times Now on one year of the NDA regime, reflects that on delivery of inflation control 53.7 per cent feel that it has failed to deliver while 43.5 per cent feel it has; the remaining 2.8 per cent are unable to decide. Such polls are subject to limitations but it does reveal that perception at the grassroots level can be at variance with official indices.

With the progressive liberalisation of capital flows and sizeable foreign portfolio investment in the government securities market, yields on Indian government securities need to be compared with those prevailing in other major markets, adjusted for inflation rate differentials. Expectations are that when the US Fed eventually tightens monetary policy, US 10-year bond yields could rise very quickly from the present level of 2.25 per cent to as much as 4.0 per cent. Again, bond yields in Germany, Japan and the UK are showing signs of rising. Against such a backdrop, a monetary policy signal from the RBI of easing policy interest rates would reduce government bond yields to levels below the 7.7 per cent level for 10-year bonds. Given the Union Government’s massive market borrowing programme, a fall in government bond yields could generate turbulence in the financial markets.

We rightly have aspirations of the present growth rates of 7.5-8.0 per cent rising to the much cherished 10 per cent rate. A prerequisite for this would be that the present gross domestic savings rate of 30 per cent of GDP would need to rise by at least 5 percentage points. Given this over-riding policy objective, a reduction in the RBI policy repo interest rate would imply a reduction in bank deposit interest rates as also interest rates on other savings instruments. This would militate against the prime objective of sustaining a high rate of growth.

It is argued that a 1.5-2.0 per cent real rate of return is adequate to garner savings. The well-known axiom is that if the real interest rate is higher than the real rate of growth, the growth of the economy cannot be sustained. At present, the real rate of interest is relatively very low and it would be only appropriate to reward the saver with an appropriately higher real rate of interest.

The policy options before the RBI are between a rock and a hard place. First, the policy repo interest rate could be lowered by say 0.25 percentage points; this could reduce the stringent criticism of the RBI. The second option could be to keep the policy repo rate unchanged. This would be the more appropriate policy response, though it would escalate the criticism of the RBI. According to tradition, the RBI chooses the policy path it feels is appropriate for the long-term benefit of the economy even if it has to face criticism in the bargain.

The writer is a Mumbai-based economist

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