Cut can hurt

If RBI has kept the interest rates unchanged, it is to cushion the volatile rupee

In his monetary policy statement this week, RBI Governor D. Subbarao took a difficult and unpopular decision. He kept the policy interest rate unchanged despite the clamour for cutting it. The decision not to cut rates was obvious if one looks at the inflation data. A 10 per cent consumer price inflation could have justified a rate hike, but given the slowdown and the pressure on the RBI, perhaps it was what a rate cut would do to the rupee that played a key role in the decision.

Most advanced countries, and a few emerging economies, have made legal and institutional arrangements to reduce the political pressure on central banks to cut rates. They have explicitly given the central bank a mandate to maintain price stability or target inflation. Industry, bankers and financial sector participants are the most vocal sections of society, and they always want lower interest rates. But most countries saw that not focusing on price stability but on growth only results in high and volatile inflation as households expect higher inflation, and higher wages creep into labour contracts, creating higher inflation.

The political solution towards the goal of achieving a low and stable inflation rate was to make the central banks independent and accountable for price stability. This way, in the political fight, the central banker could always be held up as the bad guy who raised interest rates. Normally this happens when an economy is overheating, and over time most bankers and firms call the central bank the party pooper, but accept the rate hikes. However, it is most difficult in the case of a stagflationary environment. In such an environment one would expect an inflation-targeting central bank to raise interest rates. But when a central bank, which does not have an explicit inflation mandate, resists political pressure and keeps interest rates unchanged, as the RBI did this week, many observers could be surprised, as has happened this time.

One possible explanation for what might have given RBI the determination to keep interest rates unchanged could be the fear of an even sharper volatility of the rupee if it did. For a central bank, which explicitly targets the stability of the exchange rate and faces a shrill clamour for selling dollars from its reserves, cutting rates could have created an equally unpleasant situation in the coming days. The same industrialists who are asking for rates cuts today would have demanded that the RBI prevent a rupee depreciation, without appreciating the link between the two.

The voice of those who suffer from inflation, the general public, is usually unheard. But in India's case, the story has played out in the highly visible foreign exchange market. Moreover, it has happened at a time when the most visible commentators on the currency market are often those with large dollar borrowing, who do not like a depreciation.

Consumers in India have very quietly voiced their concerns about the value of the rupee by changing their savings behaviour. Recent data for savings and investment in India shows that both fell, but savings fell more than investment did as a share of GDP. Household savings rate dropped sharply in one year, from 25.4 per cent of GDP in 2010-11 to 22.8 per cent of GDP in 2011-12. This decline in household savings by 2.6 percent of GDP came about mainly from a crash in household financial savings. In 2010-11 household financial savings stood at 12.9 per cent of GDP. This fell to 10 per cent of GDP in 2011-12, a fall of 2.9 per cent.

Households obviously respond to changes in the returns on their savings. The fall in household financial savings is widely understood to be a consequence of low real interest rates on bank deposits. The year also saw a decline in the growth of bank deposits and small savings. Had interest rates risen in line with higher inflation, real rates would have been attractive. But they did not. So households have preferred to save in real estate and gold. Physical savings of household continued to be high, and even rose slightly, from 12.4 per cent of GDP in 2010-11 to 12.8 per cent of GDP in 2011-12. The bulk of the increase in savings seems to have gone to gold. The demand for gold rose, and gold imports rose dramatically.

In many ways the fall in household financial savings of 2.9 per cent and the shift to gold, which is largely imported, constitutes a capital flight out of India, even though it appears as a current account entry. When people lose confidence in the domestic currency and move to an international asset, the demand for domestic currency declines and its value depreciates. Instead of holding rupees in bank deposits, which hardly give them any real returns, households moved to gold, pushing up gold imports and the current account deficit and resulting in a rupee depreciation.

The declining value of the rupee for Indian households would normally have been ignored, as it has been since 2006 when the consumer price inflation has been consistently above 6 per cent. However, it created shock waves when it translated into a sharp fall in foreign exchange rate. In April 2012, the consumer price index rose by 10.4 per cent and to cut interest rates in such a situation would tell households again that they should not hold rupees. Further capital flight, gold imports and lower foreign debt flows would put even greater pressure on the rupee.

The coming days will see even more difficult times for monetary policymaking. If India is to ward off a high and volatile inflation rate and provide an environment for long-term high growth, then apart from the investment climate and all other reforms the government needs to do, it must move towards an inflation-targeting central bank. Otherwise, the political pressure to cut rates, in futile attempts to push growth, can plunge India into years of higher inflation and even lower growth.

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