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'Interest'ing effects

Apr 9, 2007

After years of administered regimes, the Indian monetary as well as fiscal authorities are yet synchronising their acts to the working of business cycles. For a major part of the last one-decade, market forces have been allowed to function in the realms of interest rates and capital inflows. The anomaly comes in the working of the monetary policy between FY02 and FY06 when it has actually allowed lower real interest rates (lending rate adjusted for inflation) with higher capital inflows and an expansionary fiscal policy. By doing this, the Reserve Bank of India (RBI), to some extent, can be held responsible for fuelling the good times of the current business cycle. With elections in 19 of the next 24 months, the politicians are now harping on inflation control while the RBI is in an unenviable situation where it has to shelter the exchange rate as the current account is in deficit. This has allowed increases in the money supply. To balance the capital inflows, it will have to reduce domestic bank credit to keep money supply growth in check. This way the inflation priorities will be met and the real interest rates will also go higher to combat the growth in money supply expansion.

While the monetary policy is turning on the screws, the ongoing tightening of the fiscal policy to meet the FRBM objectives (again, a case of doing more wrong than right as the expenditure for public goods is axed rather than the costs that the economy is better off without), will work together in making this downturn sharper.

The most crucial impact of Reserve Bank of India upping the stakes in a hectic bid to avert double-digit inflation (consumer prices in rural areas are 9.5% higher over last year) will be on spending decisions and through them, on investment patterns. The hike in real interest rates affects both the private and the public sector, but the response of the private sector (accounts for 40% of the total capital formed) tends to be more magnified.

The top two hundred companies could and will raise cheaper money to finance their growth plans, as the India story still holds merit. Thus domestic interest rate hikes will disrupt life for the small and medium enterprises who employ most of the workers, while the high interest rates will attract more foreign deposits - NRI deposits already accounted for 11% of capital inflows in FY06 compared to 3.1% in FY05 when the real interest rates were the lowest in the recent history.

We continue to argue for a way to use up the reserves to avoid squeezing credit on one hand and yet raising money supply. Or else, once a turning point of the business cycle is reached - destabilising monetary policy, destabilising fiscal policy and destabilising bank credit - accentuate the downturn just as they have worked to accentuate the high of the business cycle in recent years.

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