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Unwise to raise interest rates

Subir Roy | August 11, 2004

In the near term, the Indian economy seems slated to remain in the 5.56.5 per cent inflation range, that is, assuming the 7.5 per cent touched last week is a spike.

Naturally, attention is focused on whether it is time for the central bank to signal a rise in interest rates. There is a lot going in favour of this argument, the strongest being that inflation is up not just in India but all over the world.

Since the Indian economy is getting more and more integrated with the rest of the world, remaining out of line in interest rates will have serious adverse consequences.

But conventional monetary logic nearly always ends up saying goodbye to growth, which then has other more serious adverse consequences. It is worth remembering what happened the last time the central bank went in for monetary tightening by looking at money supply and inflation figures.

That was in the mid-1990s and it ended up stymieing a healthy growth rate in industrial output. With hindsight, it is widely acknowledged that this set in motion a set of developments that took India off the path of higher growth achieved in the early 1990s.

It is also worth remembering the distinguished service rendered by the Reserve Bank of India through the Asian crisis by insulating the Indian economy from global financial markets. That went contrary to the convention wisdom of taking reforms forward by gradually removing every kind of control, including those on international capital transfers.

The cardinal lesson from global experience with reform processes in the 1980s and 1990s is that reform strategies work best when they are adapted and suited to local conditions.

One of the great gains for the Indian economy from the reform process is the steady fall in interest rates. The resultant low interest burden for Indian businesses has been one of the key drivers behind its emerging competitiveness.

Low interest rates are good for everybody and the aim should be to persevere with them and try options other than raising rates to tackle rising inflation until there is no other option left. The current inflationary upswing and expectations have been contributed in part by worries over a failed monsoon.

These worries are now partly gone, though we are nowhere near to having a satisfactory monsoon. Poor monsoon means lower agricultural output and lower farm incomes. The former can be partly tackled by importing more, whereas the latter offers no easy solution.

The whole problem with the current inflationary upswing is that it is in good part imported. Global commodity prices are up and as the Indian economy gets increasingly integrated with the rest of the world, there seems little scope of avoiding importing higher prices. But there is a way out.

Rising international commodity prices can be partly countered by lower import duties. This should be totally revenue-neutral as most duties are levied on an ad valorem basis. The only problem with this is that in all probability the finance ministry is looking forward to reaping a revenue windfall from rising commodity import prices.

It should be asked to desist and bring down duties. Easier imports will also put a damper on inflation. Domestic interests will naturally object but that is the key battle that has to be fought round the year to create greater competitiveness.

There still remains the issue of tackling the problem of too much money sloshing around, as indicated by the State Bank of India lowering short-term interest rates for deposits. A key source of accretion to reserve money, burgeoning foreign exchange reserves, should now be behind us.

It is unlikely that in the near term the Reserve Bank will have to keep mopping up dollars so as to prevent the rupee from appreciating. The contrary is likely, with the central bank having to sell dollars so as to prevent the rupee from depreciating unduly.

A key argument in favour of raising interest rates is that by now most of the earlier spare manufacturing capacity has been used up, making it difficult to quickly raise output. So if interest rates continue to be low and cheap money keeps floating around, it will end up pushing up prices.

On the other hand, now is the time when Indian industry is gearing up to undertake another round of investment for capacity expansion. This is a crucial juncture. Companies that feel confident about the future are inevitably the better-run ones, the ones that feel they can take on global competition provided they have the necessary economies of scale.

They should be able to finance their major capital investments at globally competitive costs. The last thing we should do at this juncture is raise capital costs. It is worth recalling that the East Asian economies built themselves up by allowing their businesses to set up huge capacities at very affordable capital costs.

There is no doubt that cheap money, under conditions of scarcity, tends to push up prices. It is again necessary to recall the experience of the early 1990s, when companies raised huge amounts of cash and speculatively invested it in real estate and the stock market.

The property and stocks booms were the consequences, as also the subsequent busts. Between Sebi and the Reserve Bank, it is possible to keep a watch on whether a speculative stock market boom is emerging, and if it is being financed by cheap money from banks.

As for real estate, it is urgently necessary to reform and decontrol the market for land and remove supply constraints so that real estate expansion takes place healthily and at globally comparable prices.

The way to take the economy forward is to keep Indian costs, including capital costs, globally competitive. To do this it is necessary to make huge investments in infrastructure and reduce wastage and inefficiencies in the public sector, whose dis-savings are glaring.

An obvious area to begin is the banks, whose galloping staff costs and growing interest rate spreads result in negative real returns for savers. What is needed are lower intermediation costs in the financial sector, not higher rates for borrowers.

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