T N Ninan: Monetary medicine

WEEKEND RUMINATIONS

The big debate all week has been whether the RBI was right or wrong in jacking up interest rates yet again, and squeezing money supply further. At the simplest level, the facts are that bank lending rates have gone up by about 3 percentage points over the past year, matching the inflation rate, which too has gone up by about 3 percentage points. In "real" terms, that is after adjusting for inflation, interest rates have remained unchanged from where they were a year ago. That would suggest that the RBI has got its sums right.

That does not mean an absence of pain. People who have taken home loans on floating rates of interest are hurting, for instance (I know someone who took a 180-month housing loan in 2003; after paying monthly instalments for 42 months, his bank has now told him that his instalments will continue to run for another 178 months!). The real estate market has cooled, naturally, and prices may dip even more as people start unloading properties which they had bought as investment; so new construction will slow down. Other sectors whose sales are fuelled by retail loans (like motorcars and trucks) are also beginning to feel the pinch.

Companies in other spheres too will think twice about new projects, especially if they involve fresh debt. However, most firms have a bigger cache of reserves than in the past (profits these last three years have been very good), and therefore are less dependent on loans for financing their investment. The big firms, meanwhile, have access to international borrowing at much lower rates. So Corporate India is not likely to feel the pinch as much as individual borrowers. However, a general change of expectations with regard to the future does affect everyone's behaviour.

The real problem in the coming months could be the availability (not so much the cost) of credit. This has been growing at an annual rate of 30 per cent and, despite the tightening, continues to grow at nearly the same speed. As the

RBI-administered squeeze takes effect, though, many smaller borrowers will find themselves being crowded out; to the extent that the big boys have more resources of their own, and can borrow abroad, the squeeze will hit small businesses harder. Interest rates in the informal money market could make bank rates look like charity.

What are the macro-economic implications? It is more or less certain that GDP growth will slow down from the recent 9 per cent rate, and the RBI's forecast for the new year is 8-8.5 per cent""not bad going in a slowdown.

Why then the chorus of criticism? Three points have been made. First, no one likes high and rising interest rates (other than bank depositors, lots of whom have already taken money from their savings accounts and put them in fixed deposits!), because they signal a slowing down of economic momentum; among other things, rising interest rates also tend to depress stock prices, as happened immediately after the RBI announcement last Friday. So punters are upset. Second, as Surjit Bhalla argued on this page three weeks ago, inflation is a dragon that has already been tamed, so the RBI's latest steps were unnecessary. RBI's response is to point to retail prices, which are climbing even faster than the wholesale price index.

Third, as Ajay Shah argued earlier this week, the RBI in its bid to prevent the rupee from climbing against the dollar has been buying dollars in exchange for the rupee. That only adds to domestic liquidity, and therefore to spending and borrowing power. The RBI's counter is that it has raised the cash credit ratio in order to suck this liquidity out of the system, and that a rising rupee will hit exports (which have already slowed down) because competitor countries in Asia are keeping their currency valuations low.

The arguments will go on. Meanwhile, what is clear is that the RBI has signaled its determination to tame prices, that growth expectations for 2007-08 are still in the 8 per cent range, and that over-heated markets that needed a dousing in cold water have got it.