In his interim update on the economy, timed with the completion of one year in office of the Narendra Modi-led government, Chief Economic Advisor (CEA) Arvind Subramanian has persuasively argued in favour of aggressively cutting interest rates that might also lead to a weakening of the rupee. This, according to him, is what countries like China are now doing in order to both boost domestic private investment and exports. India should follow suit with the RBI taking the lead, the CEA has suggested, while noting that the success of this government’s Make in India export drive will also hinge on a more competitive rupee. Subramanian has a point, considering that the rupee — going by the sharp increase in its real effective exchange rate or REER against a basket of currencies after adjusting for inflation differentials — is currently overvalued. The impact of it is visible in the contraction of India’s exports.
The CEA’s views on India emulating China — an economy he has tracked closely — may not, however, find takers in the Indian central bank. RBI governor Raghuram Rajan has counseled against adopting an export-led strategy that would involve subsidising exporters with cheap inputs as well as a deliberately undervalued exchange rate. In the current global economic scenario — marked by weak growth and contraction in world trade — this may simply not work.
But the larger case the CEA is making about slashing interest rates is valid. While the RBI may no longer be tracking WPI inflation, it cannot ignore the fact that this rate is currently in negative territory. Minus 2.65 per cent inflation for producers, in a scenario where they are borrowing at an average 12 per cent, translates into a real rate of interest of nearly 15 per cent. This is clearly unsustainable when both consumption and investment demand is weak and companies are saddled with unutilised capacities across sectors. Even if CPI inflation is considered, the current level of 4.9 per cent is well below the 6 per cent threshold the RBI had projected for January 2016. In short, there is a clear case for interest rate cuts today.
While the RBI has already cut rates twice this year and it may well choose to cut further in its next policy review on June 2, the fact is that cuts should now be deep enough to have a substantial impact on sentiment. Both the RBI and the government may have underestimated the extent of the current slowdown. Subramanian is right in noting that the economy today needs a strong policy stimulus in the short term. The room for such stimulus now lies more in monetary than fiscal policy. Equally, the RBI and the government — the dominant shareholder of state-owned banks — should push banks to pass on the benefits to borrowers.