N R Bhanumurthy: Why it's right to hike the interest rates

We are in the middle of the upward leg of an interest rate cycle and so the RBI reacted correctly.

Against the views of most observers, the Reserve Bank of India has hiked short-term interest rates (both repo and reverse repo rates) by 25 basis points. But this is very much in consonance with our view that the RBI should hike the interest rates (our view on interest rates was published in many dailies, including Business Standard, on January 6). Before the credit policy, many have argued that the apex bank does not require to raise the interest rates at this stage and can do it, that too, if necessary, only in the April 2006 annual credit policy. But then what made us think that the RBI should hike the interest rates? This is because of two factors: the emergence of interest rate cycles, a concept that is new to our country, and the open-economy issues.

A recent study by us on "Modelling Indian Interest Rate Cycles" showed that the current domestic interest rates (particularly the yield on government paper with different maturities) are determined by international interest rate movements with a lag and with comparatively high magnitude than other domestic factors. It was found that in the recent period, particularly since the year 2000, the domestic interest rates were showing some cyclical behaviour. This is visibly clear from the accompanied graph; by the third quarter of 2004, it (the yield on one-year government paper) has reached the trough and since then it is moving upwards. We also tried to forecast the future movements and it can be noted that the present interest rate cycle is expected to peak in the last part of 2006. In fact, we found that all the yields with different maturities show that they are expected to move upwards with short-term interest rates adjusting faster to the exogenous developments compared to long-term rates. This upturn in yields, which started in the recent period, is now is expected to taper off at a peak much lower than recorded during the high interest rate regimes in the mid-1990s.

Two reasons might have contributed to this. First, the real interest rate seems to have reached the floor during the industrial slowdown of the early 21st century. There was only one possible way to move from there on. Second, the industrial recovery from about 2003 onwards together with the rising international oil prices creating an inflationary expectation has also contributed to this upturn in interest rates. To some extent, the upturn is restrained by the easy liquidity created by the influx of foreign capital, especially in the form of portfolio investments in government securities and bonds. The cyclical movement in the interest rate during the market regime is not unexpected. It is also to be noted that the floor of the interest rate in a developing country like India is expected to be higher than that in rich countries with a surplus capital.

Why all of a sudden the presence of interest rate cycle in India? This is a very important issue in the current context. There is a need to move out of the traditional thinking process regarding the functioning of the monetary and financial system. The reason is that domestic interest rates are no more immune to foreign factors. Although they are not fully market-determined, the extent of existing deregulation seems to have led to the near-integration of domestic rates with the international interest rates. At present, it is a well-known fact that the current international interest rate cycle is already moving upwards since 2003 and is expected to peak any time from now. Following this, the domestic interest rates also needs to be moving upwards, albeit with a lag. This is a new situation for India and we need to learn to live with it in the future also.

If we don't move with the international cycle, what could be the consequence? Since 2000, as foreign capital flows, particularly short-term capital, started crossing the boarders in a big and volatile way, one felt that it had reduced the efficacy of monetary policy. The impact of these movements would be on the interest rate differentials (the difference between international and domestic interest rates), which is a very important variable for determining portfolio investments. Hence, besides domestic factors, the domestic interest rates are expected to depend largely on the international interest rates. If the domestic rates are not adjusting to the international ones, it may lead to foreign capital outflow, which again is expected to put upward pressure on the domestic rates. It may be noted that domestic banks, based on some estimates, could retain only a meagre 13 per cent of the recently matured IMD funds, which might be explained due to narrowing interest rate differentials as foreign interest rates are moving upwards. This has led to the present situation of tight liquidity, thereby, forcing some of the banks to raise the interest (both deposit and lending) rates. But the cost of capital outflow could be much higher. At this juncture one needs to remember that there is strong competition among the emerging market economies for foreign funds.

As some people observed before the credit policy, some domestic banks raised the interest rates despite no change in the RBI's policy stance. Further, the money supply growth is also at a high level above the targeted growth, together with this the large permanent component in the world oil prices means that there was no other way for the RBI except to hike the policy rates to contain the inflationary expectations. As the markets need to be managed through monetary policy signals, it was also necessary for the RBI to retain the effectiveness of the signaling factors. The policy signals are not just for the domestic economy; it is also for international investors. It is also necessary to understand that the credit policy in general tries to focus more on future (medium-term) risks and targets rather than the current (both domestic and external) economic situation. Overall, the RBI's decision to hike the rate, which we anticipated, is well-judged for the medium-term perspective.

The writer is Associate Professor, Development Planning Centre, Institute of Economic Growth, Delhi