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Leaving interest rates alone would be a heroic move - Outside View by S.S. TARAPORE
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Leaving interest rates alone would be a heroic move
Jan 18, 2013

All eyes are on the Reserve Bank of India (RBI) monetary policy announcement on January 29, 2013. Industry, government and most analysts take it for granted that the RBI would reduce its policy interest rate (i.e. the repo rate at which it provides liquidity to banks) from the present level of 8.0 per cent by either 0.25 per cent or 0.50 per cent. It is also expected that the RBI would also reduce the cash reserve ratio (CRR) from the present level of 4.25 per cent of banks' liabilities by either 0.25 per cent or 0.50 per cent. The convergence of views has been influenced by the RBI's forward guidance in its last policy review on December 18, 2012, wherein it was said, "...recent inflation patterns and projections provide a basis for reinforcing our October guidance about policy easing in the fourth quarter." In a sense, the RBI is a prisoner of its forward guidance and a reduction in the repo rate and or a reduction of the CRR is likely on January 29, 2013.

Growth Prospects

The earlier euphoria of an improved growth rate in 2012-13 is belied and it is now expected that the growth rate would be less than 6 per cent; this rate, however, compares favourably with other Emerging Market Economies (EMEs). The medium-term aspiration of a 9 per cent growth rate for the Twelfth Plan has now been scaled down to 8 per cent.


The Indian inflation rate is high, not only relative to trends in the past but it is also the highest among the EMEs. The Wholesale Price Index (WPI), on a year-on-year basis at mid-December 2012, was 7.2 per cent. The standard international inflation rate is the Consumer Price Index (CPI), which, on a year-on-year basis, in India, is elevated at a little less than 10 per cent. As in most countries, in India also, the official price indices are dampened and the 'true' inflation rate in India could well be closer to 15 per cent. Furthermore it is not meaningful to talk about core inflation ( i.e. excluding food and fuel) as food and fuel predominate in the Indian consumption basket. In other words, the heavy burden of inflation on the common person should be an overriding consideration in policy formulation in India.

Current Account Deficit

On the external front, the balance of payments current account deficit (CAD), which is the gap between current receipts and current payments, was 4.2 per cent in 2011-12 and is unlikely to be any lower in 2012-13. The external debt is mounting and now well exceeds the country's foreign exchange reserves. What is alarming is that the short-term debt is uncomfortably high, at 25 per cent of external debt, on an original maturity basis, but on a residual maturity basis, the short-term debt is alarmingly high at 43 per cent of the total in June 2012.

Taking into account the inflation rate and the weak external payments position, the nominal exchange rate of the rupee is substantially overvalued. Yet industry, government and a number of analysts advocate an even stronger rupee. A further strengthening of the rupee would defy the law of gravity. Taking into account the medium/long inflation rate differential between India and the US, the current exchange rate of US$ 1=Rs 55 is overvalued and equilibrium would warrant a rate of US$1=Rs 70, or about 20 per cent lower than the present rate. But our macho spirits would never allow the rupee to depreciate to the extent required and so the country will have to continue to live with an unsustainable external payments position.

Monetary and Credit Situation

At the present time banks are borrowing heavily from the RBI, well over the RBI's comfort zone of one per cent of banks' liabilities. On a year-on-year basis, the incremental credit-deposit ratio of banks in December 2012 was as high as 92 per cent as against 72 per cent in the previous year. Given the present CRR of 4.25 per cent and the statutory liquidity ratio (SLR) of 23 per cent, the current incremental credit-deposit ratio, it is clear that banks are lending beyond their means.

Policy Options

Given that the inflation rate is way above the RBI's comfort zone of 4.5-5.0 per cent, the large fiscal deficit, the large CAD, the overvalued rupee exchange rate, the over-extension of credit and the sluggish deposit growth, there is no case for a reduction in the repo rate or the CRR. In fact, the situation calls for tightening of monetary policy to squeeze inflation. The powerful political economy forces of industry and government will not permit the RBI to undertake the policy tightening which is necessary. It would be a heroic act on the part of the RBI to keep the present policy stance unchanged. What is likely to happen is that, in all probability, the RBI would, on January 29,2013, reduce both the repo rate and the CRR, each by 0.25 per cent.

Impact on the Common Person

While an easing of monetary policy will be welcomed by industry and government, banks will reduce deposit rates before reducing lending rates. As such depositors will be adversely affected. The present term deposit rates range between 8.5-9.0 per cent which, given the official CPI inflation rate, implies a negative rate of return on deposits. To the extent savers, in accordance with their liquidity needs, hold their savings in deposits, savers should lock into the longer maturities before the January 29, 2013 policy announcement. It would be a rational response by savers to increase investments in gold.

Please Note: This article was first published in The Free Press Journal on January 14, 2013. Syndicated.

This column, Common Voice is authored by Savak Sohrab Tarapore. Mr. Tarapore, is an economist and he runs his own Multi-Language Syndicated Column. Mr. Tarapore's other column, which appears in The Hindu Business Line, is titled Maverick View.


The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and have not been authenticated by any statutory authority. The author and Equitymaster do not claim it to be accurate nor accept any responsibility for the same. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Please read the detailed Terms of Use of the web site.

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