No shortcuts for RBI

Financial Express, 15th June 2012

Should RBI cut interest rates now that there is evidence of a slowdown in investment and output? Will an interest rate cut increase stability in inflation, the rupee, the current account, capital flows and GDP growth?

The most dramatic development witnessed in recent days has been the high volatility in the foreign exchange market and a depreciation of the rupee. The pressure on the rupee has come about due to a decline in capital flows, while the current account deficit has risen to 4% of GDP, as the savings and investment gap has increased compared to previous years.

The latest CSO data for savings and investment shows that savings fell by more than investment as a share of GDP. Household savings dropped from 25.4% of GDP in 2010-11 to 22.8% of GDP in 2011-12. This drop, of 2.6% of GDP, in household savings came about mainly due to the fall in household financial savings. In 2010-11, household financial savings stood at 12.9% of GDP. This fell to 10% of GDP in 2011-12. This was a fall of 2.9% of GDP which accounted for the lower household savings ratio.

The fall in household financial savings was a consequence of the low real interest rates households earn on their savings. The year saw a reduction in the growth of bank deposits and small savings. While the inflation rate has risen, interest rates have not risen accordingly and it is unattractive for households to save money in bank deposits. Higher inflationary expectations are now embedded in the minds of households and if a bank deposit offers an interest rate of 8%, it no longer induces households to save money in bank deposits.

At the same time, considering the inadequate social security system and lack of pensions and health benefits for the bulk of the population, the need to save remains. Households prefer to save in real estate and gold. As the CSO data shows, physical savings of households continued to be high and even rose slightly from 12.4% of GDP in 2010-11 to 12.8% of GDP in 2011-12. This has two key effects. One, real estate prices remain high and if real interest rates on bank deposits remain low, they create the conditions for an asset price bubble. Two, when households move to gold as a financial asset, the demand for gold, which has a high import intensity, rises and more gold is imported.

Inflationary expectations of households are now at double-digit levels. The government is making little effort to cut its fiscal deficit and reduce aggregate demand, the rupee has depreciated and RBI is not seen to be giving priority to controlling inflation. As output falls, the economy faces a stagflationary environment. If RBI cuts interest rates in the coming months, real interest rates on bank deposits will become even lower. This could well put further pressure on household financial savings to fall further. As a consequence, the current account deficit is likely to rise.

Even if the current account deficit does not worsen, it still needs to be financed. We could finance it by foreign private capital flows, by selling reserves, or by official borrowing. Foreign private capital flows include both investment (direct and portfolio) and debt flows. The environment for investment flows depends largely on market conditions and government policies. There is little RBI can do about those. Debt flows respond to differences in the domestic and foreign interest rates. Cutting rates at this juncture would make India a less attractive destination for debt flows. From RBI's point of view, if it wishes to pursue the stability of the rupee as an objective of monetary policy, cutting interest rates could increase the pressure on the rupee to depreciate.

Finally, the impact of a rate cut on production and investment is likely to be insignificant. One of the worse enemies of investment is uncertainty. The only outcome a central bank can deliver is to preserve the value of the currency it produces. No country has seen long-term growth rise in an environment of high and volatile inflation. That is the reason a number of countries have moved to inflation-targeting.

At present, no one in the economy expects inflation to come back to RBI's target of 4-5%. If RBI's policies do not convey that is the target it is trying to achieve, households will not believe it either. Higher inflation will continue to feed into higher wages. It will keep inflation high, real interest rates low, depress financial savings, keep the current account deficit large. Shocks in the world capital markets will hit the economy far more in such a situation.

Higher inflation will continue to put pressure on the currency to depreciate, which feeds back into tradable prices and causes further inflation. After the crisis of 2008, inflation in India has been higher than in the rest of the world. The real exchange rate of the rupee appreciated as a consequence. The depreciation witnessed last month had to come sooner or later. Unless domestic inflation rates come down, this pressure will remain.

The problem with India is the investment environment. If we try to find shortcuts for raising investment by cutting the cost of capital, we are likely to get no benefits, but higher costs in terms of macroeconomic instability. At a time when the world economy and Europe could be sources of shocks for the Indian economy, the greater our fundamental weaknesses, the greater is the risk of a crisis. In the current environment, policymakers should focus on strengthening these fundamentals.

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