Lowering interest rates is not a good idea

August 7, 2015

The Reserve Bank (RBI), on June 10, yielded to pressures of Centre and business community and reduced the repo rate by 0.25 per cent from 7.50 per cent to 7.25 per cent, keeping monetary variables like CRR and Bank Rate constant. This was to please the various actors in the economy.

There has been a cry for long, particularly since the regime of DV Subbarao (Raghuram Rajan’s predecesssor) to reduce the repo rate (interest rates). Interest rate are closely related not only with higher demand for quantity of money and cost to company, but also to many other factors.

For instance, given the quantity of real goods production and services, a decline in interest rate augments the demand for funds, which in turn, are used not only to buy goods and services for current consumption but also to finance hoarding. Additionally created money supply in the short run only inflates the prices of finished goods and production inputs.

If the increased money supply is spent on infrastructure such as road construction, irrigation projects, fertiliser and power, there can be an exponential upward price trend, because labour goods as well as ingredients of growth are not in adequate supply. This was the lesson that emerged from the 1970s’ experience in India.

Many cuts

The cost of interest is a marginal 2-3 per cent in the total cost of output. Inflation via higher money supply escalates the cost of investment goods and suppresses investment growth, besides hurting the poor. It drives the poor further to the wall.

The government, to offset the multifaceted problem, would have to provide various subsidies at the level of public distribution of foodgrain and investment activity. All this happens because of frequent reduction in interest rates and increase in demand for money.

In such an environment, RBI has to do some tight-rope-walking. It cannot be seen as playing to the gallery.

In the emerging situation of frequent reduction in interest rates, Indian business is likely to be caught in a liquidity trap. Continuous reduction in interest rate by the RBI may lead to a demand for more and more bank credit to develop the stock of liquidity in the business community.

It is likely that RBI while cutting down interest rates, has ramped up money supply. The ‘liquidity trap’ concept states that even interest rate becomes zero and the public or business world possess lot of liquidity, they would still borrow from banks and hold on to the cash. Can the RBI countenance such a situation?

Matter of interest

Consider the present situation of the depreciating Indian rupee due to foreign investors’ flight from Indian market.

They are converting their rupee holdings into dollars which has resulted in higher stocks of domestic money supply, leading to fall in external value of rupee. Similarly, higher liquidity of the rupee in domestic market has resulted in the depreciation of the rupee against goods and services, which implies inflation.

It is surprising that the government too is favourably disposed towards reducing interest rates. The issue is that repeated decline in interest rates is going to adversely affect domestic savings due to re-emerging inflation and falling rates on savings in the form of financial assets. This cannot be good for growth.

There is no doubt that the lower interest rates will substantially benefit the borrowings of the Union Government. It is common knowledge that the public sector is the monopolistic borrower in the domestic market, and so it would like to keep interest rates at a lower level.

Instead of this, the government should reduce further its fiscal deficit and not borrow from the domestic market, which should be left for private sector.

As for the private sector, it would be more beneficial for them to improve productivity comparable with that of China and US. Unless we increase our productivity and add to industrial innovations, we will not rise up the global economic ladder.

Moreover, interest accounts for 2 per cent of costs of the business world. Hence, we have to look into the weaknesses of the Indian economy, and more importantly the corporate world, rather than inventing catchy slogans.

MY Khan
The author is former Economic Advisor, SEBI

This article was published on July 29, 2015 ( Business Line)