Wednesday, January 23, 2013

Why RBI needs to RAISE interest rates

On 16th January 2013, speaking at an outreach programme of the Reserve Bank of India (RBI) at Lalpur Karauta village in the state of Uttar Pradesh, India, Governor Dr. D. Subbarao said this: "If you see the currency note, it is printed on it that 'I promise to pay the bearer the sum of Rs 100' and it has my signature as the RBI Governor. What does the promise and signature mean? It means that the RBI will control inflation and maintain its purchasing power". It is another matter that the stream of journalists present did not report this very important statement (see here, for example) when they filed their reports on the event. Either they did not really understand what the Governor said, or did not like what they heard.

If you read the pink press regularly, or watch one of those stock market channels masquerading as ‘business’ channels, you might be forgiven to think that the RBI Governor sits in his office holding a magic wand in his hand. All he needs to do is to waive the wand lower, and lo! All the country’s economic problems would be solved! This magic wand, the press might tell you, is called The Interest Rate. So much is the pressure from interested politicians, crony capitalists and the media on the Central Bank to reduce rates, that one would be inclined to believe that that’s all that is there to managing an economy.

Subbarao has a promise to keep - to maintain the purchasing power of our money

The truth however, is not so simple. When it comes to the interest rates, the mainstream media is not just wrong, it is preaching exactly the opposite. Let us therefore be clear – beginning to reduce interest rates right now will take the country on the path of ruin.

Let us understand why I am saying interest rates need to be raised.

Inflation is still running frighteningly high. As per the latest figures, Consumer Price inflation (CPI) is at 10.56 % per annum. Food prices have increased by 13.04 %, with several key ingredients such as oils & fats (16.73 %), vegetables (25.71 %), sugar (13.55 %) rising at a much faster pace. Being official figures, even these figures may be grossly understated. Prices of several items have as much as doubled in the past year. The index does not even include the dramatic increase in the prices of services like transport  and education.

Bank lending is already growing faster than deposits. For deposits to catch up, interest rates need to be raised. RBI has pointed this out in the last mid-quarter monetary policy review on 18th December 2012. In December, borrowings from RBI’s LAF (Liquidity Adjustment Facility) reached highest level for the year at Rs.1.70 lakh crore and are still running high at almost Rs. 80,000 - 1 lakh crore this month (see this or  this). To put it simply, banks as a whole are lending more than what their deposit base justifies.

The high rate of inflation and the shortage of deposits with banks clearly point to a need to raise, and not lower interest rates. Even the slight dip in wholesale inflation rate (WPI) from 7.24 % to 7.18 % that is being bandied around is far higher than RBI's 'comfort level' of 4 - 5 %.

Lowering interest rates ignores the interests of savers completely; it presupposes that borrowers are the only ones interested in interest rates. Lowering interest rates punishes savers, rewards borrowers and encourages profligacy. An economy should be built on solid foundations of high savings rate, and not on high borrowings. If savings are high, plenty of money will be available for productive investment, and this in turn will cause rates to move lower. Low interest rates are thus an outcome of a healthy economy, lowering rates artificially cannot automatically lead to a healthy economy.

In its Financial Stability Report released last month, the RBI has stated that low real interest rates are causing diversion of savings to hard assets like property and gold. Lowering rates further will worsen this trend.

Raising rates strengthens the currency, something India badly needs to do. India’s foreign exchange problems are well known and need not be elaborated here.  At a time when the country is trying to attract foreign capital by opening up new sectors for foreign investment, what justifies discouraging domestic savings?

Lowering interest rates now will worsen these trends, causing a further rise in inflation, erosion of savings, flight of deposits from the banking system and weakening the currency.

Vested interest and sheer ignorance promotes the myth that somehow low interest rates are  ‘good’ and high rates ‘evil’. The debate in the mainstream media is so one-sided that the merits of raising the rates or keeping them high are not even discussed. The bogey of low industrial growth and high Non-Performing Assets (NPAs) is raised every time to oppose raising or justify lowering the rates. But industrial growth has been slow mainly because inflation is eating away into people’s savings, leaving people with little money to spend on other things. High NPAs have been a result of various factors like the policy mess (e.g. power sector), poor business plans (e.g. aviation) or simply, in the words of the Finance Minister himself, “poor lending decisions”, not to mention willful defaults and corruption (e.g. real estate). I have not come across any instance which points to high interest rates as the primary cause of an asset turning bad. The rates simply aren’t that high.  

If high interest rates are not a cause of the problem, lowering them cannot be the solution as well.

The villagers of Lalpur Karuata, like the rest of us, will soon know whether Subbarao keeps his promise.

1 comment:

  1. it is simply anti-national on your part to suggest to do development by bringing & encouraging FDI without telling the nation that FDI (proposed to be brought in India)is nothing but round tripping of Indian black money stashed in Swiss banks using Mauritius route in the guise of P-Notes flouting/exempt KYC norms.

    Next question intentionally not discussed is if USA can resort to Quantitative Easing (QE)(that too for those already flush with liquidity used ultimately
    (i) either in carry-trade by using their money from low-interest currency areas and investing in high-interest currency areas so that they can earn without doing any hard-work)
    (ii) or invest their excess cash generated through artificial QE in countries like India (whose policies are manipulated to give benefit to FDI seekers)using FII route in indian equity to artificially pump-up indian stocks; after selling at artificial pumped -up prices run away thus making it a case of flight of (hot-money)thus taking artificially huge un-earned profit margins leaving the local currencies running for cover

    why should India not resort to QE for those already needing money for their real economy instead of bogus economy whose various bubbles are appearing unabated in the USA and EU areas.
    In spite of this clear evidence of failure of FDI (or even if are sure of its success)Question is why should we make progress with their wealth (instead of indian wealth including indian QEs) does not it not tantamount to transferring indian ownership to foreigners. If you know this actually is the case, your intention is to make the nation slave which shall always be resisted till India rightly bent upon in showing its status actually dumps its traitors. Thereafter, real face of Indian strength will be visible in no time. World has seen one Narender Modi; wait for the deluge of Modis.