Saturday, April 13, 2013

Interest Rate debate begins

B. Yerram Raju
Annual credit policy is due by May 13. The demand for easy money policy is on pressure zone following what Japan did. The Economist in its issue dated 6th April 2013 is emphatically unsupportive of the cheap money policy ushered in by the new governor of Bank of Japan. The lower interest rate regime in the post-recession period 2008-09 would appear the new normal. Bank of England and the European Central Bank also tweaked lower interest rate regime to last longer than expected. Does this justify the cry of corporate community in India to follow suit to give boost to the manufacturing sector and growth? Will the current inflation rate allow such intervention? What has been the result of the brief interest rate cuts that had already surfaced?

The lowest bank rate that Indian economy witnessed was 2.5% in 1936 – during war time. The target of rate cut was not growth of the economy but the sovereign balance in the British colony. Now Indian economy has come of age but the global integration left the so-called decoupling with the rest of the world a near impossibility.

Kenneth Rogoff, a Harvard University Professor says: “Like most economists, Bernanke believes that if policymakers try to keep interest rates at artificially low levels for too long, eventually demand will soar and inflation will jump. So, if inflation is low and stable, central banks cannot be blamed for low long-term rates.” But the Indian situation is different. We have inflation soaring. Growth is down and under. Current account deficit is raising its ugly head with 6.7% last month and a bourgeoning fiscal deficit that refuses to be reined in with General Elections less than a year away from now.

The so-called economic resurgence and effective regulatory interventions that kept India’s growth rate high in the Eleventh Plan period are now turning out to be only things of the past. Manufacturing growth is at just 2.5%. Agriculture and services sectors are not in any rescue mode.
The priority for the monetary authority is clear as has been repeatedly asserted by the Governor, Reserve Bank: reining in inflation for its impact on the poor is far more than any direct tax imposed on them. The rate cuts in the past though in small bouts of 0.25% every time, has not triggered credit growth in the areas most desired. The risk appetite is at the low end because of the high NPA levels in corporate and infrastructure credit. Even the corporate debt restructuring indulged in liberally and the capital refurbishing by the government to the public sector banks would not leave enough confidence in the regulator to resort to a rate cut as a panacea for the current imbroglio in growth.
What will the rate cut do anyway?
If the Banks were to respond positively, they should reduce their base rates and lending rates correspondingly. The rates on deposits of key segments will have to be lowered to ensure that the net margins do not erode. If the interest rates on deposits are lowered, propensity to save will take a backseat. Bond rates in this scenario despite being attractive,  are not safe bet for investors in the context of high debt-GDP ratio. There is need to increase the incentive to save as the domestic savings rates have been coming down during the last two years consecutively. Low interest rates are not certainly going to help the situation. If the inflation is at 9% and interest rates for term deposits are on average at 8.5% the negative return is 1.5% or the depositor paying this much for safety and security of his funds to the bank.
When the market rates of interest are not influenced by official rates even marginally credit is unlikely to spur production of goods and services. Further tighter regulation of lending standards and Basel III implementation deadlines also force banks to step up bank lending to the much starved SME sector increasingly difficult. This will give rise to the operation of a vicious cycle.
Monetarists strongly believe that a mere reduction in the quantity of money is a dangerous device to stop an inflationary development. Moderately used, as Hansen says: ‘it courts the failure of ineffectiveness; pushed to the needed fanatical extremes, it courts disaster.’
There should be a many-sided programme to control inflation:
1.      First hold down government expenditure to what is urgently necessary so that budgetary surplus can emerge.
2.      Resist the temptation of incentivizing FTAs through tax-cuts. There is a demand to reduce taxes on luxury goods like CKD SUVs to 30% and such demand should not be conceded.
3.      It is necessary to resist wage-inflation: periodic increases of DA at Central Government level triggers demand at State government levels and this spiral would lead to price-wage increases – both a symptom and a further cause of inflation.
4.      Inflation indexed bonds should be sold vigorously.
5.      There is no room for relaxed credit standards.  In the context of board-sanctioned credit triggering huge NPAs, all the proposals that go to the board should be scrutinized by risk management committee and credit committee separately and a balanced view on entertaining such proposals shall be taken. There is need for looking at Board accountability.
6.      Speculative areas of credit like the real-estate howsoever tempting should be avoided.

What can’t be cured must be endured. We must learn to live with existing rates of interest for some more time to come until the fiscal corrections come about and policy initiatives to secure more foreign investments bear fruit. Japan now is no guide for India’s future.