Should the RBI hike rates further?

DEBATE

Continued inflationary pressures and rising NPA levels probably call for a rate hike but this could exacerbate things in an economy which is in any case slowing.

Ashvin Parekh
Partner, Ernst & Young

"High inflation needs reining in and slower growth means higher NPAs for banks "" all of which calls for a hike in interest rates"

The upcoming second quarter review of the monetary and credit policy by the RBI on July 29 is expected to infuse another dose of monetary tightening into the Indian economy. The economic landscape has toughened from the time of the last review in April when the Governor decided to leave the interest rates untouched while increasing the Cash Reserve Ratio (CRR) by 50 basis points. High inflation, increased oil and food prices, slump in equity markets, reduced GDP growth projections and political uncertainty have contributed to an unfavourable economic scenario. In view of the current economic scenario, the regulator seems to have little choice but to further tighten the monetary reins of the economy.

Inflation touched 11.9 per cent for the week ending June 28 with no signs of slowing down in near future. It has adamantly remained above 11 per cent throughout the last month. According to some, it could further increase to 17 per cent by end of this year. Consistent high inflation has led to an increase in banks' cost of operations (in terms of increased cost of raw material, labour, etc) for companies, which are already constrained by high cost of funds and slowing demand. Further, with an apparent slowdown in the economy, the level of non performing assets (NPAs) is also expected to go up in the near-term. Banks will have to factor in these increased NPAs in their cost of loans. Thus, going by the clearly expressed policy views and the high cost of funds, the regulator is expected to increase the repo rate by 50-100 basis points besides increasing the CRR by another 50 basis points.

The overall business of banks would be affected due to a negative impact on their intermediation function. Both time and demand deposits earn a negative return, in view of high inflation. On an average, time and demand deposits earn a return of 9 per cent and 3.5 per cent respectively. Accounting for an inflation of around 12 per cent, it leaves a real return of about minus 3 per cent and minus 8.5 per cent respectively for depositors. This is further expected to worsen in view of increased inflation expectations in the near future. Clearly, it would impact the banks' ability to mobilise low-cost deposits, further increasing their cost of capital. Consequently, banks would be forced to offer higher interest to depositors to meet their deposit-mobilisation targets for the year. Deposit rates rose to around 15 per cent in 1995 when inflation was at around 12 per cent, clearly indicating that there is still plenty of scope of a hike in the existing deposit rates. An increase in deposit rates would require banks to increase their loan rates in order to protect their spread.

Further, there has been no hike in the reverse repo rate for a long time, which resulted in banks getting a much lower return (6 per cent) on their excess funds from the RBI as compared to what they have paid (7.75 per cent) to borrow/mobilise funds. This wide gap in repo and reverse repo rates also translates into increased interest rate variations in money markets. An expected increase of 50-100 basis points in the reverse repo rate would provide some more comfort to banks in offering higher returns on deposits.

Amit Mitra,
Secretary General, FICCI

"Most of the inflation is in items that are not sensitive to rate hikes "" so we could end up reducing growth while not tackling inflation"

Is an interest rate hike in the forthcoming credit policy the right tool to 'cool the economy'? The contention that the Indian economy is overheated is buttressed by the inflationary trend in India that gathered strength beginning March 2008. Interestingly, while inflation has gone up significantly, aggregate growth rate has not slowed yet. The expansion plans of Indian entrepreneurs too have not been cut back. However, if at this juncture an interest rate hike happens and credit squeeze policies are set in motion, FICCI fears, that on the one hand inflation will not come under control, and on the other hand, we will slip into a growth deficit. In other words, in attempting to control inflation one may kill the goose that lays the golden egg.

FICCI studies have also demonstrated that the current inflation is deeply rooted in primary articles, particularly food articles and non-food articles. Our research indicates that these are insensitive to interest rate variations as a large proportion of food producers are not deeply linked to bank borrowing and changes in the interest rates. This further lends evidence that an interest rate hike and a bank credit squeeze will be ineffectual in bringing down inflation.

The mainstream macro-economic literature emanating out of developed countries often establish causality between interest rate hikes and inflationary control. The developed economies are characterised by 'complete markets', seamless information flows across their economies and a near 100 per cent monetisation where bank lending and interest rates are used by all layers of enterprises.

Unlike developed economies, India and other emerging markets are characterised by incomplete markets, fractured flow of information and (in case of India) 93 per cent of employment arising from the informal sector that only partially uses bank credit with interest as their price of borrowing. We all know that moneylenders are found in 'community committees' and offer finance in small borrowing clusters none of which are driven by bank interest rates. Therefore, a mechanistic approach drawn from developed country macro-economic literature may not be as effective in India as in advanced economies.

However, the small percentage of SMEs that do use bank credit will be pushed into a danger zone. Moreover, the small percentage of the economy comprising large industry that depends on bank finance for growth and is the one that would drive the economy into the next growth phase, would take a severe hit and could bring down overall economic growth. Given the reality of India at the grassroots level, we will have to use the mainstream economist's tools with appropriate assumptions and innovative perspectives.

With this indigenous model bolstered by the fact that inflation seems to be insensitive to interest rate variations as per FICCI research, the Reserve Bank will have to be cautious. An aggressive rate hike and credit squeeze may result in entrepreneurs postponing or scaling down their brownfield and greenfield expansion plans. And if this happens, then we may see the existing situation of supply constraint getting intensified and leading to more inflationary pressure. The ominous and lurking fear is that we must not reach the 'tipping point' where attempts to handle inflation through monetary policy results in the economy moving towards stagflation.