The case for cutting rates
Financial Express, 28 December 2007
The RBI should cut interest rates in the next credit policy announcement. Both the repo and the reverse repo rates should be cut. There are a number of good reasons to do this. First, the government wants to prevent rupee appreciation. Internationally, rates have been cut, which is putting further pressure on the rupee. Restrictions on the capital account have failed to prevent rupee appreciation. Second, the Indian business cycle may see a downturn with the slowing down of the US economy. A countercylical policy requires a pre-emptive reduction in interest rates. Third, the present policy of keeping interest rates high and trying to prevent rupee appreciation is actually more inflationary than cutting rates would be. The RBI should indicate to the market what it will be doing in the credit policy and not leave everybody guessing.
One of the biggest difficulties for RBI in keeping interest rates high is the inflow of capital that it invites. Despite efforts at bringing back capital controls, capital flows through ECBs and other channels have flourished. A key factor driving this is the cut in interest rates in the US and Europe, which has further increased the interest differential with India. It is, therefore, not surprising that even after the curbs on ECBs, August 2007 saw USD 1.5 billion, September saw USD 2.2 billion and October saw USD 3.6 billion come in as ECBs. The impact of the restrictions has been that the number of companies borrowing abroad has come down after the restrictions but the amount of borrowing is still large. In June, before the restrictions 88 companies borrowed a total of USD 2.8 billion. In October, two months after the restrictions, 30 companies borrowed USD 3.6 billion. While this data only reflects the size of the borrowing and indicates that the size of the average loan has gone up, it is likely to be caused by a bias against smaller companies who, as international evidence suggests, usually lose out when capital controls are imposed.
Morever, curbing ECBs is unlikely to do the trick. ECBs between April and October account for only USD 19 billion. Foreign currency assets with the RBI increased by USD 53 billion over this period. As long as the interest differential remains high, capital will continue to flow in. This would not have been a problem had the RBI not bought dollars on a massive scale in implementing currency policy. But since it does so, it increases liquidity and creates inflationary pressures which then further strengthens the logic for keeping interest rates high. This creates a vicious cycle in which the RBI can keep on increasing interest rates and then buying up dollars. Sterilisation of its intervention reinforces higher interest rates. When the RBI auctions government bonds to mop up liquidity in the system, it puts upward pressure on interest rates which, in turn, invites more capital.
In this financial year, even though the RBI did not cut the repo or reverse repo rates that act as signals for the banking system to move rates, and indeed the CRR was raised, many banks reduced their deposit rates since April. This has come about because of the downward pressure that higher liquidity in money markets has put on interest rates. So even though, de jure the RBI had a policy of not reducing rates to combat inflationary pressures, the increase in liquidity meant that de facto monetary policy was much looser than that stated. Despite no change in policy rates, or any cut in CRR, bank deposit rates have come down since July.
Advance tax payments have tightened liquidity in the last few weeks but as soon as this pressure goes away, we are likely to be back in the old situation of RBI intervention raising liquidity beyond its sterilisation capacity. This would anyway put a downward pressure on interest rates which will encourage banks to lower deposit rates further. But the reverse repo acts at 6 percent as the lower bound of the interest rate corridor. This, therefore, needs to be cut. However, to go back to an interest corridor of a 100 basis points as in the original LAF framework, the RBI needs to cut the repo rate, currently at 7.75, as well. Now that concern about high credit growth has abated with the decline in credit growth, this is not a difficult choice as it was until a few months ago.
In text book macroeconomics, when a central bank faces inflationary expectations it must raise interest rates. However, in the case of an open capital account this works only when the exchange rate is flexible. In a situation when the central bank is going to try to manipulate the exchange rate, higher interest rates actually end up being inflationary. The illusion that we can control capital flows while maintaining high interest differentials has been negated by data for 2007, where capital flows have not been blocked by capital controls. The illusion that all inflows can be sterilised if there was a blank cheque for MSS bonds has been negated by the pressure that MSS autions have put on interest rates. If the RBI will not have a market determined exchange rate, it has to cut interest rates. The impossible trinity demands that if India has an open capital account, and insists on exchange rate pegging, then autonomy of monetary policy has to be given up.
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