The pros and cons of RBI rate cut

What is required is change of growth strategy, from foreign finance-led to exports & domestic growth

Outside the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), there is growing clamour for a cut in the interest rate. The main arguments put forward by the proponents of rate cut are that the inflation rate is now low, that investment has been on the decline and needs to be revived, and that capacity utilisation in industry remains low. 

The MPC, on the other hand, argues that the core inflation and inflationary expectations are in fact still high. It also argues that a lower interest rate can neither revive investment nor increase capacity utilisation in a situation where companies are debt-laden and banks are burdened with non-performing assets. Other policies are required to deal with these problems.

What is puzzling in all this is that neither side in the debate mentions the policy “dilemma” that arises from the fact that India’s economy is open to flows of international finance so that the interest rate and the exchange rate cannot both be controlled. A change in the interest rate has consequences for the exchange rate, which has effects on inflation, investment and growth.

I have deliberately avoided using the commonly used term “policy trilemma” because India’s “import-oriented” growth strategy is, and has been for quite some time, premised on availability of foreign finance. During 2004/05-2015/16, the trade deficit was high, between three and seven per cent of GDP. Despite the cushion provided by the inflow of remittances (three-four per cent of GDP), the current account deficit remained between one and five per cent of GDP. The deficits were financed by inflows of foreign capital. In most years, the actual inflow was in excess of what was required to finance the current account deficit and the excess added to the country’s foreign currency reserve.

Inflow of foreign finance depends both on monetary policies of the advanced countries, particularly of the US, and on monetary policies of the recipient developing countries. Until recently, the advanced countries maintained zero nominal interest rate and resorted to quantitative easing (money printing in simple language). So, financial flows to developing countries were large. But India’s monetary policies were still relevant for attracting inflows; the interest rate in India determined whether the flows went to Brazil or came to India. Monetary policies of the advanced countries have now changed; quantitative easing is no longer in use and the nominal interest rate is being gradually raised. In this setting, the interest rate is of even greater importance in sustaining inflows of foreign finance.

This is where, I suspect, the real but unstated reason for the RBI’s reluctance to reduce the interest rate lies. Even with unchanged interest rate, the inflow of foreign finance is most likely to decline. A reduction of the interest rate can only make the decline steeper, resulting in a serious depreciation of the rupee. Such developments would threaten to increase inflation, bring insolvency to companies that have borrowed in foreign currency, and usher in lower economic growth. The growth of services, linked significantly to capital inflows, would be directly squeezed and curtailment of merchandise imports would squeeze the growth of other sectors. The negative impact on manufacturing, which has become increasingly dependent on services incomes from the demand side and on imported inputs from the supply side, would be particularly strong.

The point is that the RBI is not in a position to use monetary policy to stimulate the economy fundamentally because the growth strategy being pursued requires foreign finance inflow to be maintained at a high level. Indeed, it is difficult to see how the RBI can even pursue its core mandate of maintaining the inflation rate between two and six per cent.

What is required is a change of growth strategy, a transition from foreign finance-led growth to growth driven by both exports and domestic demand. To achieve this, the focus of policies would have to be on achieving current account surplus and not on financing deficit. Growth of manufactured exports would require stimulation and import-dependence would need to be curbed. This will be helped by policies that encourage inflows of FDI (which are not sensitive to interest rates), particularly into manufacturing, while restricting non-FDI inflows (which are sensitive to interest rates). Growth of domestic demand can come from income growth in agriculture and rapid growth of agriculture would have to be a major component of the strategy.

The author is honorary professor at the Institute for Human Development, New Delhi