The Reserve Bank of India is going to announce its review of half-yearly monetary policy on October 27 . The RBI Governor, Dr D. Subbarao, recently indicated that, in view of the inflationary pressures building up, India may have to go for tightening of monetary policy before the developed countries do so. This has created apprehension in industry circles that the days of cheap money may be over soon.
But is this the right time for a hike in interest rates? Most economists do not think so. Their argument rests on several pillars.
First, it is possible that the economy, despite negative growth in agriculture (due to drought), may still clock a 6 per cent plus growth rate this year. Though this is a respectable growth rate amidst a global recession, it is still much below the potential growth rate of 8 per cent plus.
There are indications that the growth engine is gaining speed. So, if the brakes are slammed now through an increase in interest rates and reduction in liquidity, the economy may lose its momentum and it would be forced to grow much below its potential.
Further, the Government can not afford to run the huge fiscal deficits which it is doing now to combat the effects of global recession and drought in the Indian economy. If monetary tightening takes place along with fiscal contraction, the adverse effects on growth would be even stronger.
Second, even if there are some early signs of the developed Western economies coming out of recession, there is considerable uncertainty about its durability. The private households, in particular, have suffered a huge wealth destruction caused by the fall in home and stock prices. Now they are desperately trying to build up assets by cutting down their consumption expenditures.
Jobless growth
Since the turnaround in unemployment rate lags behind the turnaround in GDP growth rate, the fear of jobless growth is still very real in the US and Europe.
This is further restraining consumption expenditures as unemployed people are in no position to spend. In addition, a significant part of the recovery is due to the huge stimulus packages thrown in by governments.
It is not clear what would happen when the stimulus funds are gradually withdrawn by the governments in such countries.
Full recovery in economies such as India’s cannot take place without the export growth rate reaching their pre-recession levels. But that may take a couple of years.
Third is the nature of the current inflation. According to WPI, the inflation rate is just about a per cent. By CPI measure, the inflation is in double digits. This is because of the sharp rise in prices of food items such as rice, sugar, pulses and vegetables.
In other words, the high inflation (CPI) is primarily due to sector-specific supply side factors getting worse by the drought. Some of the industrial commodity prices are also largely determined in global markets, beyond the control of the Indian policy makers.
Since there is no general excess demand problem at home fuelling inflation, the tight money policy will be largely ineffective to contain it. The most likely effect of a fall in aggregate demand as a result of contractionary monetary policy would be on growth of output, not prices.
On the contrary, restrictive monetary policy, by raising the interest cost of production and distribution operations, may increase prices further. The measures needed to tackle inflation have to be supply side initiatives like offloading from buffer stocks and imports and discouraging hoarding of commodities.
Fourth, the growth rate in non-food credit is still much below the pre-slowdown rate. So, there is no evidence of an excessive overall money supply growth in the economy. According to Planning Commission experts, we need a credit growth of above 20 per cent in order to support a GDP growth rate of 7-8 per cent.
Interest rates
At present, the credit growth is around 14 per cent while the bank deposit growth rate is 20 per cent. If it is felt that cheap and abundant liquidity is threatening to fuel bubbles in the stock and real estate markets that should be checked by selective measures such as increasing the risk-weights and provisioning requirements on loans going to these specific sectors.
Fifth, any rise in interest rates will increase the cost of Government borrowing and would have significant upward push on the already alarming budget deficits, especially when the Government has no option but to spend more on stimulus packages and drought relief measures.
Further, if growth in industrial production is adversely affected by a restrictive monetary policy, tax revenue collections will suffer, aggravating the fiscal deficit.
Finally, for some time following the onset of the global financial crisis, the US dollar was steadily rising against the Indian rupee as investors and central banks were switching to the US dollar, the safe haven asset in times of global turmoil.
Now that the situation has stabilised, investors are coming back to emerging markets like India. As a result of massive capital inflows, the rupee has now started to appreciate. This would adversely affect the export industries and would have a negative impact on the growth rate.
If RBI raises interest rates at this juncture, it would further encourage funds to flow to India in search of higher returns (unless it is offset by expectations of a fall in the price of rupee in future), causing further appreciation of the rupee and depressing the growth rate.
So, all considered, a general tightening of monetary policy is not the right option at this point of time. The RBI will have to keep its monetary policy (interest rates and supply of credit) tilted in favour of growth for some more time in the game of growth-inflation trade-off.
Source : Business Line