The RBI believes that changes in the interest rates will affect the exchange rate

Last week, in his credit policy announcement for the coming year, the RBI governor, Bimal Jalan, did not cut the bank rate. Instead, he said, “a reduction in the Bank Rate by up to half a percentage point (50 basis points) will be considered by RBI as and when necessary.”

Interesting, that he should say 50 basis points. Why not 25 or 100 basis points? Presumably, he is following the finance minister’s lead who cut the PPF (Public Provident Fund) rate by half a percentage point.

But then, when he has already been given the cue why not cut the bank rate right away? Mr Sinha had after all cut rates on small savings, the ostensible reason for which was to reduce the level of interest rates across the economy. And, that was the politically more sensitive cut. Mr Jalan only had to follow the lead.

So, why did he choose not to? Among the possible reasons why the bank rate was not cut there are three which emerge as good candidates.

First, could the decision be a sign of “the loss of independence of monetary policy” — the classic “impossible trinity” dilemma where a country with mobile capital flows cannot have both a fixed exchange rate regime and an independent monetary policy?

Not that India has a textbook version of a “fixed exchange rate regime”. But since the RBI tries to keep exporters happy by not letting the rupee appreciate and attempts to keep foreign investors confidence up by not letting it depreciate, it does a tight rope walk and in effect tries to keep the rupee stable.

The implications for policy are similar as those of a fixed exchange rate regime. The interest rate has been used as an instrument to stabilise the rupee in earlier episodes of pressure on the rupee. This indicates that the RBI believes that the financial sector is open enough for changes in interest rates to affect the value of the rupee. And, under these circumstances if the RBI governor reduces interest rates when international rates are back on an upward trajectory he may believe that it would put pressure on the rupee.

Second, it could be that the RBI governor has given up hope of raising growth by cutting interest rates. The channel from interest rates to economic growth in India is expected to be mainly through investment. As pointed by Manas Chakarvarty in “Why not bank on the consumer?”, Business Standard, (May 2), the transmission mechanism through which interest rates impacted the US economy has been through a rise in consumer spending. Consumer loans became available at much lower interest rates and helped push up demand.

In India the share of consumer loans remains low despite the pick up in housing finance. Investment that should have picked up, at least in theory, failed to do so. This should hardly come as a surprise. In the past no clear relationship has been observed in India between interest rates, real or nominal, and private investment activity. Evidence to suggest that interest rate cuts raise investment has been weak.

But as in most recent models of the Indian economy, one includes an interest rate variable even though its coefficient is insignificant. This is done on the belief that by doing so the model will represent the present better. So even though historical data suggests no significant influence of the interest rate on investment, it is hoped and assumed that it would do so in today’s market economy. It is often more a matter of faith rather than empirical evidence.

In other words, whether in an explicit macroeconomic model, or in that one equation the central bank governor has in his mind, there is, one expects, an assumption that a cut in interest rates would lead to an increase in investment. Has the governor now dropped that assumption?

If he has one cannot really blame him. After all the Japanese experience is that despite zero interest rates investment has failed to pick up. Investment, it appears, depends more on expectations and business confidence and less on interest costs, than one might have believed. To add to this is the governor’s recent experience where both interest rates and investment activity have been moving downwards. He has not seen his rate cuts doing anything much to push up investment. So how long can he hold on to his belief of an inverse relationship?

But maybe it is not that. There could be a third reason. That the governor has not given up on interest rates as such, he has only given up on the bank rate — on the efficacy of the bank rate as an instrument of bringing down interest rates, even if there is a need to? The last time that the RBI cut the bank rate commercial banks failed to follow.

As the governor pointed out in the credit policy “the sharp reduction in nominal and real interest rates (for government securities, the bank rate and short term rates) is not yet fully reflected in the interest rates generally charged by banks on advances.” He identifies the cause of this as the high average cost of bank deposits, their high intermediation costs that push up spreads, poor debt recovery systems and the government’s borrowing programme.

He further recognises that, given various constraints (including public ownership in the banking sector and legislative provisions), especially poor debt-recovery systems, actual progress in reducing average spreads is likely to be slow.

In other words, it is unlikely that if the bank rate is cut any further it will get translated into a cut in the lending rates of commercial banks unless these structural problems of the banking system are solved. And, since that seems unlikely in the current year, what will constitute a situation that warrants a cut in the bank rate by 50 basis points?

Notably the governor says that, “In relation to the average rate of inflation of 3.6 per cent during 2001-02, it is evident that the real interest rates on long-term paper, the Bank Rate and short-term rates are now fairly reasonable. ” Will this indicate that the situation will warrant a bank rate cut when inflation goes down even further? Are we heading towards zero inflation? Not if we go by the credit policy’s own forecast — which is a rate of inflation of “slightly lower than 4.0 per cent”.

It would be interesting to see when the RBI governor actually lowers the bank rate during the current year and the situation that warrants it. If his present mood is anything to go by the situation will not arise.