Jul 24, 2000|
Should the RBI have raised CRR and Bank Rate?
For starters, the recovery in the Indian economy is still weak. The current up trend is largely due to a rise in consumption demand. Investment demand continues to remain dull. And it is the latter that is of greater importance for a long-term recovery to take root.
Letís look at investment demand in greater detail. Two factors that are a prerequisite for investment demand are the marginal efficiency of capital and interest rates. This is pretty logical, as businesses would invest only if they expect to earn more than a benchmark (the Ďhurdle rateí) from their incremental investments. The other key factor is interest rates. Our focus is on the latter.
Higher interest rates increase the cost of money and as a result contribute to a slowing down of economic activity. Letís look at it this way. Higher interest charges would influence consumer demand to the extent they are financed by external sources. Businesses on the other hand would witness inflation in cost structure, as debt servicing costs rise. This could influence them to defer investment decisions (as they would be costlier to put up and also the demand scenario would be adversely affected). Together these factors would affect the aggregate demand in the economy.
The RBIís move may have been too strong (if it results in banks raising their prime lending rates). For a central bank, which currently has foreign currency reserves in excess of US$ 33 bn (equivalent to over 7 months of imports) the need for such a measure could have been deferred, especially in light of the weakness in economic recovery. The depreciation in the value of the Rupee infact is acceptable in view of the recent flare up in inflation (currently it has stabilized at around 6%) and the pull out by FIIs (as indicated by sales pressed in domestic markets).
The RBI is probably taking a chance that banks will not raise lending rates as they were anyway expecting rate to rise in view of the large government-borrowing programme. If this turns out to be true, the after effects of the RBI's recent move will be muted. On the other hand if lending costs were to rise, corporate India (and the Indian economy in general) could once again be faced with challenging times.
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