Cut rates now

Indian Express, 17 January 2008

The latest data for industrial production shows a slowdown in growth. Industrial production grew by merely 5.3 percent in November 2007 over the same month last year. In November 2006 industrial growth was much higher at 16 percent. These numbers are for one month only, and do not indicate that there is a general slowdown in the Indian economy. But if we look at other indicators as well we find that the picture today is quite different from last year. In 2007, discussion about the Indian economy was focused on whether the economy was overheating. Overheating refers to high inflation rates with high capacity utilisation backed by high credit growth. It is a situation when it looks like the demand is growing faster than what the economy is capable of producing. Last year, when growth and inflation were both high, the discussion about overheating shaped policy debates. However, standing in January 2008 the picuture looks quite diferent.

Inflation, measured both by the Wholesale Price Index (WPI) and the Consumer Price Index (CPI) has dropped. Inflation based on the WPI has now been in the range of 3 to 3.5 percent, down from 6.6 percent in March 2007. Inflation based on the CPI (Industrial-Worker) has come down from 7.5 percent in February to 5.5 percent. Our perception of inflation needs to adjust for the fact that petroleum product price increases have been artificially held back. However, this will not raise the inflation rate significantly for more than a few weeks after the adjustment is made. If WPI fuel rises by 1 per cent, it will raise the WPI inflation rate by 0.2 percent in the first 3 weeks. This effect would fade away in 10 weeks.

The current numbers for industrial production and inflation thus suggest that the Indian economy is no longer showing signs of overheating. The contraction in economic activity has been achieved mainly through a series of monetary policy measures such as hikes in interest rates and in the cash reserve ratio.

Another element in the picture is the rupee appreciation, which is said to have hurt exports. However, some of the sectors where exports in rupee terms have fallen sharply, have not declined as much as might have been feared. In April to November 2007, the production of cotton textiles grew by 5.5 per cent, textile products grew by 5 percent and the leather goods grew by 12.2 percent. In contrast, the sector that grew much more slowly at a negative rate of 0.7 in November, and merely 2.7 since April was transport equipment, an interest sensitive sector. In other words, higher interest rates did shrink demand, at least in some sectors. The production of consumer durables fell by 4.1 percent in November 2007 over last year. While the consumer durables index that is used to measure durables production suffers from many problems, the fall of the consumer durables index by 1.7 percent in April-November over the same period last year was partly due to slowing down consumer credit.

The policy measures undertaken in 2007 thus managed to achieve a relative cooling down of the economy. What does this imply for economic policy today? Should policy makers continue with the policy stance that was suitable for an economy that was in danger of overheating? Or, does the new situation warrant a policy change? The stance of monetary policy will have to be decided in the next two weeks or so, that is, by the end of January when Governer Reddy will announce the monetary policy for the coming quarter.

In addition to the data about growth and inflation, an important factor that will influence the RBI's decision will be capital flows into India. As the balance of payment data for the July-September quarter indicates, there has been a doubling of net capital flows into India. In the second half of 2007 while the US Fed lowered interest rates, RBI continued to raise interest rates. Higher interest differentials have made India an even more attractive destination for capital flows. These put pressure on the Indian rupee. RBI's has attempted a distortionary solution - of bringing back controls - but this has limited effectiveness. Further, when RBI purchased dollars in the foreign exchange market to prevent further rupee appreciation, it pumped liquidity into the system. The net effect was that instead of being deflationary, higher interest rates ended up as a policy that increased liquidity and inflation.

Today the expectation of a recession in the US is higher than ever in 2007. Further, the expectation of a US Fed rate cut are higher today than before. This suggests that if the RBI does not reduce interest rates, the interest differential between the US and India will go up further. This would attract capital into the country, and put further pressure on the rupee to appreciate. However, further appreciation is not politically acceptable.

In this scenario cutting interest rates is an attractive option. By reducing capital flows, it will ease the pressure on the rupee to appreciate. This, in turn, will reduce the purchase of dollars by the RBI and help reduce the liquidity it is pumping into the system. In a normal market economy, lower interest rates could be inflationary. But in India, where RBI persistently trades on in the foreign exchange market buying dollars, lower interest rates might actually help reduce inflation.

There are thus two reasons suggesting that it is now time for RBI to cut rates. First, Indian interest rates are above those of the US Fed, and the gap is likely to widen as the US Fed cuts rates. This will attract capital into the country. Given the desire to prevent rupee appreciation, it is better to just have lower rates so as to attract less capital into the country. Further, the global and domestic macroeconomic outlook has shifted into sombre territory. Fears of overheating have been replaced by fears of a slowdown. Both lines of thought lead to the same answer: Cut rates now.

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