The kindest cut

After global markets responded sharply to news of a weakening US economy, the US Fed cut rates sharply by a whopping 75 basis points. This should be an important factor in RBI8217;s credit policy announcement at the end of this month. As it was, in an environment when the profit growth of companies has slowed down, when exports are slower and talk of GDP at 10 per cent and an overheating economy has faded, it was time for the RBI to be sensitive to both inflation and growth. The Fed rate cut increases interest differentials between India and the US. High interest differentials are already attracting high capital inflows into India and putting a pressure on the rupee to appreciate. A 8216;do nothing8217; policy is not safe since the RBI is worrying about the rupee. Last year, the 12 per cent appreciation of the rupee created such a hue and cry among exporters that it is unlikely that the government will be willing to accept any more appreciation. This means that the RBI will mop up the additional dollars in foreign exchange reserves. An increase in reserves would push up liquidity and be inflationary. To reduce the pressure both on the rupee and on inflation, the best thing for the RBI to do would be to reduce the incentive to bring more money into India.

For this, it will need to reduce interest differentials.

Even if the RBI is concerned about world food and oil prices, as Governor Reddy has indicated, it must now cut interest rates. Without help from an accommodating monetary policy, given the stated goal of preventing rupee appreciation, the wrong set of measures could cause a lot of harm. It could hurt growth like it did in the mid-1990s, bringing on a recession that India may otherwise be able to avoid.

Interest rates in India are very high 8212; higher than most parts of the world 8212; both because of high policy rates and because of the high margin that banks charge. These margins can be brought down by reducing the cash reserve ratio CRR that the RBI increased this financial year when there was a risk of overheating. The increase that was implemented should be reversed during this financial year through a pre-announced timetable. If there is a need to tighten liquidity, it can be done through selling Market Stabilisation Scheme bonds.