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Economic Graffiti: Don’t be cautious, RBI

Central bank should be more aggressive in cutting the repo rate. It must signal that this is the direction it will pursue in the foreseeable future.

Written by Kaushik Basu | Published: August 18, 2017 12:02 am
Reserve Bank of India, rbi, repo rate, repo rate cut, RBI policy, demonetisation, GDP gowth, indian express news, business news Though a big segment of India — private firms, banks and finance specialists — take a keen interest in RBI policy action, many ordinary citizens treat this as an abstruse topic, of no concern to them. Illustration: C R Sasikumar

The Reserve Bank of India’s recent decision to lower the repo rate was a move in the right direction, but I am of the view that it was not strong enough. Instead of cutting the rate by 25 basis points, it should have cut it by 50 and signalled that this is the broad direction it intends to pursue in the future.

Though a big segment of India — private firms, banks and finance specialists — take a keen interest in RBI policy action, many ordinary citizens treat this as an abstruse topic, of no concern to them. In reality, the lives of ordinary citizens are greatly affected by it. However, this happens so unobtrusively that it is easy to be unaware of it.

Hence, let me begin by explaining why this is important. The repo rate is the interest rate at which banks can borrow money from RBI for short durations. It stands to reason that, if this is lowered, banks can lend to their borrowers at lower rates. This is the reason why changing this rate usually influences interest rates across the economy and in the same direction. It is also standard wisdom that raising the repo rate lowers inflation but also restrains growth, while lowering it pushes up the growth rate but fuels inflation.

There are several reasons why I believe the RBI should be more aggressive in cutting the repo rate and also giving forward guidance that this is the direction it will pursue in the future.

First is the fact that there is no indication of rapid, generalised inflation in India. There may be single-item price spikes, but these are caused by structural factors and bottlenecks, not overall liquidity in the economy. In an emerging economy like ours, it is good to have an inflation rate of around 3 to 4 per cent. This makes the labour market more flexible and facilitates job creation. India’s inflation has been falling over several months and is now well below 2 per cent. If anything, India now has a risk of sustained low inflation, which we know from the experience of other countries, most notably, Japan, can cause overall stagnation.

Second, India’s growth needs a shot in the arm. As a result of the liquidity crunch associated with last November’s demonetisation, overall GDP growth in India is now down to 6.1 per cent per annum. It should have by now gone back to over 8 per cent which is where it had been on a sustained basis since 2003, till the time of the global financial crisis. Some additional liquidity could partially offset this.

Further, a fact that is getting little attention but can cause long-run slowdown in India is the drop in the amount of investment taking place in the country. India’s investment-to-GDP ratio had risen since 2003 and was holding steady at above 35 per cent. This was a major factor fuelling the country’s high growth. This has now dropped to approximately 28 per cent. The positive relation between how much money a country allocates to investment, especially in long-run infrastructure, and how fast its GDP grows is one of the more enduring findings in economics. We have seen this in the case of East Asian countries that grew rapidly during the 1970s and ’80s. All of them invested over 35 per cent of their GDP. To get back to high investment, banks in India have to be given leeway to lend more and one instrument for this is a lower repo and reverse repo rate, which would allow banks to lower their interest rates and that would encourage entrepreneurs to borrow more and invest in long-run projects.

These are fairly standard arguments but there is another reason behind my recommendation that is not talked about enough. The world is today caught in a low-interest rate regime. The European Central Bank pioneered this by cutting its overnight deposit facility rate to below zero, specifically to -0.10, in June 2014; and this prompted central banks in other countries — Sweden, Denmark, Switzerland, Japan, Hungary — to cut policy rates and enter negative territory.

It is now increasingly evident that this is not good for these countries because such extreme low rates are, far from boosting consumption, making people save more since they are worried about not having enough money at the time of their retirement. This has created a classic “trap” that economists talk about: No country can individually break away from it without doing damage to itself. It is easy to see this. If one of these countries raises interest rates, in today’s globalised world, money will flow into the country from the other economies in order to earn the higher return. And as more players try to buy this country’s currency to invest in it, the currency will appreciate, causing exports to suffer. It is clear that it is for this reason that the Bank of Japan, after cutting its current account deposit rate to -0.10 in January 2016, is not able to pull away sharply from this.

And it is not just these nations, all big players are caught in this. Even the US Fed is more cautious about raising rates than it would have been, since it does not want to raise the demand for dollars which would cause the dollar to appreciate and hurt American exports.

This is where India is erring. By holding on to high interest rates, it is attracting capital flows into the country, as evidenced by the large foreign exchange reserve held by the Reserve Bank. I believe this is causing the rupee to be stronger than it should be and this is, in turn, stunting exports, and also growth.

An economy is a complex machine and its well-being depends on a fine balance of policies that have to be crafted by the best professionals. The RBI’s policy action is just one instrument and I do not want to over-emphasise its significance. But at this juncture, it could have played a major role in steadying the Indian ship and even speeding it up a little.

The writer is C. Marks Professor at Cornell University and former Chief Economist and Senior Vice President, World Bank

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  1. K
    kulaputra kulaputra
    Aug 20, 2017 at 6:31 am
    Economy is complex machine - well said Mr Basu. I speak as a job creator. Please do address the role of intermediaries - banks. When the interest finally comes to me, it is between 12 to 18 for short term borrowing provided I give enough collateral. I wonder who can possibly have confidence in future business to confidently borrow at those rates ? I can buy homes at lesser rates than I can create jobs. There are two distinct rates here - the one which banks and RBI transact in and the second which is what the bank offers small and medium businesses. They seem to be in different orbits. Aren't banks responsible for bad growth, lending recklessly and adjusting for recklessness by taxing those who repay.
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    1. Krishnamoorthy Iyer
      Aug 20, 2017 at 6:22 am
      Some people are interested in getting their own advantages only. WHY DO YOU FORGET THAT MANY ARE PULLING ON BANK DEPOSIT INTERESTS ONLY!! NOW AGAIN WHY YOU HAVE NOT " CARED" TO LOOK INTO " INFLATION" TO COMMON MAN . WHY YOU WANT COST OF LIVING BENEFITS "DEARNESS ALLOWANCES". IF poor people are neglected think about consequences.
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      1. Damodar Biswal
        Aug 19, 2017 at 4:42 pm
        For creating employment opportunities in the industrial sector huge ins utional assistance need to be fed into the system .This is possible when when the repo rate is reduced.RBI should realise the problem n take appropriate steps before it is late.
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        1. R
          Rajesh
          Aug 19, 2017 at 3:02 pm
          Its fashionable to blame anyone who doesn't agree with you or do what you want. It may be industrialist or bureaucrats or economists. What has europe or japan acheived by lowering interest rates? Import export is just not only dependent on the exchange rate. Quality b ing is an important factor, which requires lot of hard work. No one wants to put that in. Our exports be it merchandise or sotware services have thrived on labour arbitrage weak currency. Let them reinvent themselves or perish. Something better will come out of it. Those who are doing quality work are not facing much challenges in India or in exports. Others need to follow their example. Already we have had more than 2 points reduction in interest rate but nothing much has changed in manufacturing nothing much will change. There is lot of disruption going on which is too much to stomach for our industrialist who have mostly grown because of crony capitalism.
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          1. O
            Observer
            Aug 19, 2017 at 1:32 pm
            And pray, what will millions of savers and retirees who depend on bank interest do? The only safety net that the vast majority of Indians have, is ones own savings. And in India too, if savings go down, people start consuming less. Fact is that corporate crooks want cheap money, at the expense of the depositors. RBI is right. Does growth dfepend ONLY on cutting interest by another .25 ?
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            1. Damodar Biswal
              Aug 19, 2017 at 4:48 pm
              Growth will happen only when industrial growth takes place dustrial growth will happen when adequate money is fed into the system.Rising interest rates r not conducive for industrial development.It may be noted that employment generation depends on industrial growth.So,the entire economy wants bank rates to come down.For people like u,sir,the Govt has devised a special scheme,where one can get higher rates of interest on deposits. A reduction in the rate of interest is the need of the hour.
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