INTERVIEWS
SPECIALS
CHAT
ARCHIVES

Business Commentary/ R C Murthy

A case for taking calculated risks in rate cuts

Finance Minister Yashwant Sinha virtually forced the Reserve Bank of India governor Bimal Jalan through his February 27 Budget to act on the monetary policy front.

By presenting a Budget least inflationary under the existing circumstances and gearing the fiscal policy for economic revival through a multiplier effect, Sinha signalled that the credit policy should buttress his prescriptions.

The monetary policy has undergone a radical change over the past year. Gone are the days when Jalan's predecessor, C Rangarajan, followed inflation-centric policies. In fact, he was obsessed with it and rightly so.

Jalan is also not following proactive policies as in the days of Manmohan Singh when the latter was at the RBI helm. They are neither here nor there now.

The biannual credit policy formulation has been made a non-event, as Jalan himself put it. Now he proposes procrastination of reform of financial institutions.

I had argued earlier for a sharp bank rate cut of 1.5 percentage points to give a fillip to the economy. Jalan has taken the plunge all right. But caution is his watchword. The bank rate was cut by one percentage point to eight per cent a fortnight back.

That has been expected of Jalan since his policy, as he outlined elsewhere, has been to stir the market the least. Fortunately, coming as it did on top of a market-friendly Budget, even the one percentage point cut proved a good stimulant to market sentiment.

Had the cut been 1.5 percentage point, the corporate sector as a whole would have been the biggest beneficiary. The markets would have been in an extended bull phase.

A turnround in industry is crucial. The GDP growth next fiscal will inch up rather slowly unlike in the year about to end. The 5.8 per cent GDP growth this year is because of fortuitous circumstances.

From a lower base arising out of a fall in agricultural production last year, even a normal increase this year appears magnified. This is a sort of statistical illusion.

No such advantage will accrue in the new fiscal unless there is an exceptionally good monsoon. The GDP growth would thus depend largely on the fortunes of industry and services sectors.

Moreover, as India opens up its economy as part of globalisation, foreign companies with financial muscle will set up shop here, placing local firms at a disadvantage. Indian corporate sector depends largely on high-cost bank credit as they are under-capitalised.

Besides, a drop in interest rates is in keeping with the policy of harmonising domestic interest rates with the rest of the world. A further cut in interest rates does not hit hard commercial banks either. Their earnings may be hit to an extent. But economic revival would help improve corporate repayments against debt and contribute to lowering their non-performing assets.

Would a sharper cut lower the real interest rates substantially to turn negative and affect domestic savings? In advanced economies, real interest rates rule 3-4 per cent, close to their GDP growth.

In India, however, there is a need to keep real interest rates positive at all times. For high domestic savings are a sine qua non in a developing economy like ours. At 26 per cent in India, the savings rate is fairly high but not comparable to South Korea and China.

On that basis the ruling interest rates, called nominal interest rates in economic jargon, will have to be much higher in India because of sizable inflationary pressures. World inflation rates have been 0 to 3 per cent.

On the other hand, inflation in India is currently around five per cent. There was some success at inflation control over the past couple of years, with the price rise almost halved from the recent peak of eight-odd per cent.

Last year's official Economic Survey had suggested that "4 to 6 per cent inflation rate could be regarded as an acceptable level for India at present". With the discontinuation of the automatic monetisation of Central government's deficit, there is now greater scope for monetary policy to be effective.

How can the economic revival be buttressed? A push for housing construction, on which an upturn in demand for steel and cement depends, is the key for a turnaround.

The Credit Policy for the slack season (May-October) should be geared for accelerating the economic revival. The policy formulation should not be made a non-event.

But April/May is not the time for a major initiative on the interest rate front. Inflation has been around an annual five per cent, just one percentage point below what is considered the threshold. According to an RBI study, six per cent is the inflation threshold and a rate higher than this optimum level can have adverse consequences for GDP growth.

Whether or not the Bank rate should be cut further depends on expectations of price trends in the lean season. If the next monsoon is good, kharif crop prospects improve and inflationary expectations ebb, offering room for manoeuvrability to the RBI.

A cut of 0.5 percentage point in the bank rate would be too little to have an impact. Jalan should take a calculated risk and opt for at least 0.75 percentage point cut in July if the monsoon trends are favourable.

Also, by then the fiscal trends in the first quarter of the new year would be available. To what extent Sinha has shed the "roll-back FM" image and how determined he is to restrict the fiscal deficit would be known by then. Sinha should be supported if he is on track.

R C Murthy

Business news