As 2005 gets under way, the Reserve Bank of India is faced with the following picture.
US interest rates are starting to increase, foreign institutional investor inflows are starting to slow down, industrial investment is picking up, agriculture is turning in good crops, inflation is staying well over 5 per cent, forex reserves are remaining high, and importantly, political pressures of the populist are continuing and need to be taken into account while making an assessment of the fiscal situation.
As the institution charged with determining the price of money, the RBI has to take a view on what interest rates will be, or at least ought to be, in 2005.
On one hand, it would not want to slow down the long-awaited investment boom that is on; on the other, it will not want prices to start rising faster than they are at present.
Its problem on the price front is compounded by the fact that thanks to the low inflation of the past few years, the inflation threshold has come down significantly.
There are many ways of discussing the issues involved above. One of the more important ways is to talk about the real interest rate. This is the difference between the rate of inflation and the nominal interest rate. However, it makes little sense to talk about it without reference to the rate of growth of GDP.
Therefore, the real issue to be settled is this: given that at around 6.5 per cent India is the second fastest-growing economy in the world, should the real interest rate be high or low?
The received wisdom on the subject is that it should be low. But the Chairman of the Prime Minister's Economic Advisory Council, C Rangarajan, has a different view*.
He says it takes a long time for growth rates and real interest rates to converge. So "in the meantime, in fast-growing economies the real rate of growth will have to be higher" than is assumed appropriate for developed countries.
He cites the example of South Korea during the high growth phase when the real rate of interest was around 6 to 7 per cent for several years.
He underlines the point further and refers to the Taylor Rule, which prescribes that the rate through which the central bank signals should be fixed by "taking into account the deviations of the inflation rate from the target and actual output from its potential".
His central message is that policymakers need to distinguish a situation where the real rate is high because of high growth and where it is because of market imperfections of whatever kind.
It is important that "the real interest rate be kept at a level necessary to generate the savings and investment needed to support rapid economic growth."
Let us see how far this view gels with the RBI's current thinking on the subject. This is available in the latest Report on Currency and Finance, 2003-04.
It should become a must-read for all those with an interest in the subject. Rarely does an official document provide such a depth and width of views and analysis with such clarity.
The report appears to endorse Dr Rangarajan's view that real rates will remain high in India because "the potential growth rate is higher than the actual growth rate, and if expectations regarding future growth are strong".
In other words, the more talk there is of 7 or 8 per cent GDP growth, the greater is the likelihood that real interest rates will remain higher. (Clearly, one lesson is talk less, work more).
But this also means that investment demand will be less, with consequences for output growth. The report says that for India "estimates for 1970-2003... suggest that a 100 basis-point rise in real interest rates depresses real GDP and widens the output gap by five basis points in the short run. The impact increases over time and the long run impact is almost 40 basis points".
In short, we are being told that what applies to the developed economies does not apply to developing ones. So those who advocate a convergence between growth rates and the real interest rate should zip their mouths.
*Challenges for Monetary Policy, Kale Memorial Lecture, 2004
