This is no time for rate hike

Financial Express, 9 October 2009

RBI Governor D Subbarao has hinted at a rate increase sooner than that in developed countries. At the same time the Reserve Bank of Australia raised interest rates. It is the first G20 country to have raised rates. The question this raises is whether RBI will raise interest rates soon?

What are the factors that should shape RBI's decision on interest rates?

The most important factor is growth. Is growth back on track? There are three important aspects to this question. First, while 6-6.5 GDP percent growth might look high in comparison with growth in the US, UK and Europe, it is below India's decadal average. The Indian economy, as in the case of other emerging economies, does not witness business cycles around a zero percent growth rate. As a developing country, growth rates are much higher and fluctuate around a long term trend. While the issue of calculating this trend is difficult, and there is plenty of academic debate on it, one simple way of looking at it is to think of the trend as a decadal average. This, looking back, is roughly 7 - 7.25 percent for India. Further, if we think of this as a long term potential growth rate for India, then as long as we are growing below this growth rate, there is space to expand, and growth faster, and, when we are above this potential growth rate, policy makers need to watch out for signs of overheating and of inflationary expectations.

The second aspect that matters for growth in India is global conditions. While most people agree that the worst is over, the question of whether the recovery is U-shaped or W-shaped is still not on. It is not entirely clear that when the effect of fiscal stimuli of the G20 countries wears off, growth will contine, and if so at what pace. Until this unfolds, there will remain a significant amount of uncertainty in the world. Indian business cycles are highly sychronised with global, and especially, US business cycles. If there is a W shaped recovery in the US, we may find that the growth we have witnessed in the last two quarters may seen a downturn again. To take a concrete example, export growth of automobiles recovered thanks to the support offered by European and US governments. Will this growth be sustained after the concessions end? The answer is that it is too soon to say.

The third aspect to consider on the growth front is growth of non food bank credit. Are businesses, especially small businesses, which are one of the biggest engines of growth in the Indian economy getting access to credit. The disruption caused by the crisis to non-bank credit puts more of the burden on bank credit. Looking at month on month seasonally adjusted data we find that until the September 2008 credit crisis, non food credit series was growing at above 20 percent on a monthly basis. In the period immediately after the crisis it slipped to below 10 percent. It is still below the pre-crisis levels, and below the RBI target of 20 percent. The growth of bank credit is normally coincident with economic activity and as long as this is below desirable levels, any action that could restrict this growth, would not be desirable.

One of the important factors that will shape RBI's policy of interest rates will be the impact of an interest rate hike on the exchange rate. Higher interest rates will increase interest differentials and attract foreign capital inflows. This will put pressure on the rupee to appreciate. As Governor Subbarao pointed out, this will raise questions about what the RBI should do: a) allow it to appreciate, b) prevent appeciation by intervening in forex markets and allow larger liquidity, or c) prevent appreciation and then sterilise its intervention. The first, i.e appreciation, could hurt exports. The second, i.e unsterilised intervention, could raise concerns about excess liquidity, and the third, i.e. sterilising its intervention would not only put further fiscal burden on an already stretched fisc, but it would also make the RBI's job of selling government bonds even harder. After considering how undesirable all of these outcomes are, the RBI would be reluctant to raise rates for fear of capital inflows.

And, finally, of course, there is the question of inflation. There is confusion on whether to look at core inflation (WPI inflation minus food and oil inflation), or to look at the CPI which is affected by flood and drought and could be tackled by better supply management, or to look at the WPI, which does not say anything about anybody's consumption basket. Further there are questions about the effectiveness of interest rate policy on inflation in India given the weak monetary policy transmission mechanism and other issues that Subbarao raised in a speech last month when he was arguing why the RBI cannot focus on reducing or stabilising inflation as its focus.

In summary, growth and credit conditions do not indicate that it is time for the RBI to raise interest rates and higher food inflation, by itself, is not a sufficient reason to do so.

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