Charge of the rate reduction brigade

In the run-up to the Reserve Bank of India’s Third Monetary Policy Review for 2015-16 on August 4, 2015, the interest rate reduction brigade will be active with loud beating of drums and blowing of trumpets. The present government, after making the right genuflections about the prerogative of the RBI to determine policy interest rates, will promptly start haranguing the RBI in public that the policy repo interest rate should be reduced.

Chief Economic Adviser Arvind Subramanian fired the first salvo in the middle of June by saying that real interest rates are “whopping” high. Arvind Panagariya, vice-chairman of the NITI Aayog, has been voicing the same view. Predictably, in the next few days, the minister of state for finance, Jayant Sinha and the finance minister, Arun Jaitley, will voice similar views.

The global economy has experienced eight years of unprecedented quantitative easing with close to zero policy interest rates. Increasingly, there are strong expectations of a reversal of policy interest rates in the US in 2015 which could be one of a series of ‘tantrums’ that global financial markets are likely to witness. The Bank of International Settlements (BIS) has been unequivocal in its warning that global interest rates are too low and could pose growing risks to financial stability. The BIS stresses that policy normalisation should come sooner rather than later as debt burdens are rising to unacceptable levels with a build-up of financial imbalances. Claudio Borio, the much respected head of the BIS’s monetary and economic department, summed it up as the financial system being one of “too much debt, too little growth and too low interest rates”. The BIS warns that “normalisation of policies will be bumpy as low interest rates have given rise to a faulty debt fuelled global growth model”.

A bird’s eye-view of the domestic economy points to a real GDP growth rate in 2015-16 of around 7.8 per cent, which would be the highest in the world. We should be more than satisfied with this rate of growth but ‘aspirations’ of both the erstwhile UPA government as well as the present NDA government is for the magical double digit growth rate. It is unfortunate that the emotional call for a 10 per cent real rate of growth is so strong that ground realities are ignored.

A number of issues have to be factored in:

(i) We live in an increasingly integrated global economy and with sluggish global growth it is not realistic to expect the Indian economy to grow at 10 per cent.

(ii) Gross domestic savings have fallen to 30 per cent of GDP and even assuming a capital-output ratio of 4.0, a 10 per cent growth rate would require a 38 per cent gross domestic savings to GDP ratio, assuming a current account deficit of 2 per cent of GDP.

(iii) A low rate of interest militates against the need for a higher rate of savings.

(iv) The 7.8 per cent growth projection for 2015-16 is premised on the services sector leading the pace of growth. The Index of Industrial Production as of May 2015 shows a growth rate of only 2.7 per cent. Again, with monsoon uncertainties, agricultural output would, at best, be around the average of recent years or even lower.

(v) The Consumer Price Index (CPI) inflation rate on a year-on-year basis for June 2015 is 5.4 per cent and tentative estimates for the target date of January 2016 point to an inflation rate of around 6 per cent.

(vi) Indian exports have been a cause of anxiety for a number of months.

(vii) There are clear signs of a deterioration of asset quality in the banking sector and there are lurking fears that the actual non-performing assets (NPAs) could be much higher than revealed.

In this context, the call by government, industry and analysts for lower interest rates is totally inappropriate. Lower policy rates would sooner or later translate into lower lending rates but the malaise of the economy cannot be remedied merely by interest rate reductions. Moreover, policy interest rate reductions would feed into lower deposit rates which would lower savings in financial assets.

Ultimately, the RBI has to take the right call. One could equally argue that far from lowering interest rates the appropriate policy response should be to raise policy interest rates. It is better that the RBI is criticised for taking the right decision rather than taking the wrong one to please the powerful galleries, but be condemned by history for wrong decisions.

The constitution of the monetary policy committee, as recommended by the Financial Sector Legislative Reforms Commission (FSLRC), has been a contentious issue. The FSLRC recommends a seven-member committee composed of two RBI executives and five external members with a veto power for the governor. The committee chaired by the deputy governor, Urjit Patel recommends a five-member committee consisting of three RBI executives and two external members with no veto for the governor.

Subramanian recently claimed that the RBI and the government are on the same page. The issue is not only of who appoints the external members but more importantly the number of executives and external members. This leads to the issue of accountability. If the external members are in a majority there is no way accountability can be determined. Accountability is an executive function and not the function of the advisory. The sooner this is understood the better for a viable system.

The writer is a Mumbai-based economist

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