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.
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