X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2018 Edition) on picking money-making stocks.

This is an entirely free service. No payments are to be made.


Download Now Subscribe to our free daily e-letter, The 5 Minute WrapUp and get this complimentary report.
We hate spam as much as you do. Check out our Privacy Policy and Terms Of Use.
RBI's finest hour is yet to come - Outside View by S.S. TARAPORE
  • MyStocks

MEMBER'S LOGINX

     
Login Failure
   
     
   
     
 
 
 
(Please do not use this option on a public machine)
 
     
 
 
 
  Sign Up | Forgot Password?  

RBI's finest hour is yet to come
Feb 10, 2014

On January 28, 2014, Governor of the Reserve Bank of India (RBI) Raghuram Rajan, raised the repo rate (the lowest rate at which the RBI provides accommodation to banks against the collateral of government securities) from 7.75 per cent to 8.0 per cent. With the Consumer Price Index (CPI) for December 2013, year-on-year inflation rate of 9.9 per cent, the policy rate hike needed no explanation. Yet, considering the powerful lobbies, which are averse to the slightest increase in policy interest rates, Governor Rajan has set out a convincing justification for the increase.

Overall growth

The RBI expects the real GDP growth in 2013-14 to be a little below 5 per cent; while agriculture has shown improvement, industrial output is stagnant and services show a distinctly lower rate of growth.

The problem in India is that monetary tightening, during the upswing of the cycle of growth, is fiercely resisted by powerful economic agents, most prominently the government, as they want the party to get merrier. The resistance eases, reluctantly, only when inflation crosses double digits. By the time action is taken, output is on the decline and fears develop that monetary tightening would further slow down the growth of the economy. The lower income groups suffer the ravages of inflation the most and financial savings decline as savers move into physical assets.

The moral is that the suffering of the common person would have been alleviated if policy interest rates had been raised aggressively during the upswing of growth, well before policy and deposit interest rates became negative in real terms. There are, however, political economy considerations which prevent timely action.

Inflation and policy interest rates

A legitimate question raised by some analysts is why, on some occasions, the RBI raises policy interest rates and why on other similar occasions, it refrains from policy action. It is argued that both in mid-December 2013 and end- January 2014, the overall macroeconomic situation was broadly similar, but there were different policy responses. The harsh reality is that political economy considerations hold sway over monetary policy and skillful rationalisation of policy decisions is required.

Faced with this situation, the RBI has to use every window of opportunity to tighten monetary policy. It is gratifying that the opportunity was taken on January 28, 2014 to increase policy interest rates.

Deposit and lending rates, inflation

As of December 2013, the average deposit rate of banks was 7.7 per cent, while the average lending rate was 12.1 per cent. The political economy pressures are to reduce lending rates, but this would imply a reduction in deposit rates. The reduction of deposit rates would only accelerate the diversion from financial assets to physical assets. With an inflation rate of 9.9 per cent, deposit rates at all maturities are negative.

The repo rate should be positive in real terms and above the term deposit rate for say one year. At the present time, deposit rates of one-year maturity are well above the repo rate, and hence banks have incentives to draw on RBI accommodation. The repo rate would need to be at least two percentage points higher than what it presently is. Political economy imperatives prevent such increases in policy interest rates.

To bring about an alignment of interest rates, the RBI needs to take every window of opportunity to increase policy interest rates, but resist reductions in policy interest rates till such time as the present distortion in policy interest rates is rectified.

Inflation as a policy anchor

Critics of the Patel Committee Report argue that a tilt towards a rule-based monetary policy would be detrimental to overall welfare and that there is merit in a flexible policy. In the absence of an inflation anchor for monetary policy, it would be difficult to resist the clamour for reduction in policy interest rates.

From a current inflation rate of 10 per cent, the Patel Committee 'glide path' of a less than 8 per cent inflation rate for January 2015 is apposite. Reducing inflation through 2014 would warrant a relatively tighter monetary policy stance than at present, and in any case, easing monetary policy should be ruled out. To the extent inflation comes down, it would obviate the need for large increases in the repo rate.

Given the poor interest rate transmission, we do not seem ready to manage policy without the use of the cash reserve ratio (CRR). A combination of a repo rate hike and a CRR hike would require a smaller increase in the repo rate than exclusively relying on a repo rate hike. Hence the RBI should not be averse to using the CRR instrument.

Encouraging financial savings

Unless decisive action is taken to increase the effective rate of return on financial assets, not only will there be a shift from financial assets to physical assets, but overall savings willd fall. Inflation Indexed National Savings Securities linked to the CPI were introduced in December 2013.

The scheme is on a cumulative interest basis and hence excludes the major constituency for savings, which needs interest income to meet day-to-day expenses. It would be a great success if the government were to provide half-yearly interest. With this amendment, savers would flock to this instrument.

RBI's finest hour

It is well-known that January-June 2014 will put serious limitations on other wings of economic policy. This would put a disproportionate burden on monetary policy.

The RBI should hold up the rear and relentlessly pursue its monetary policy with its sights fixed firmly on the inflation objective of less than 8 per cent for January 2015. This could be RBI's finest hour.

Please Note: This article was first published in The Freepress Journal on February 10, 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.

Disclaimer:

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.

Equitymaster requests your view! Post a comment on "RBI's finest hour is yet to come". Click here!

  

More Views on News

What They Forgot to Tell You About Sensex at One Lakh (Smart Contrarian)

Nov 29, 2017

Stocks that could beat Sensex returns in the long term.

How to Ride Alongside India's Best Fund Managers (The 5 Minute Wrapup)

Jun 10, 2017

Forty Indian investing gurus, as worthy of imitation as the legendary Peter Lynch, can help you get rich in the stock market.

4 Things To Do When You Are Not Able To Pay EMI (Outside View)

Feb 22, 2018

PersonalFN lays down simple steps to take if you find paying EMIs difficult.

This Investor Lost US$ 444 Million! How You Can Avoid the Same Blunder... (The 5 Minute Wrapup)

Feb 22, 2018

Here's how you can minimize losses if you have invested in the wrong company...

Is This the Most Absurd Government Agency? (Vivek Kaul's Diary)

Feb 22, 2018

Is this government agency doing the job of sounding an alarm if the financial system were ever in danger?

More Views on News

Most Popular

The Foundation for Sensex 100,000 is Laid(The 5 Minute Wrapup)

Feb 17, 2018

Top three reasons for Tanushree's presentation at Equitymaster Conference to be centered around a possible 30% correction.

The Era of Easy Money is Coming to an End. What Happens Now?(Vivek Kaul's Diary)

Feb 9, 2018

The easy money policy of the Federal Reserve of the United States, which drove up stock markets all over the world, is ending, with the Federal Reserve looking to shrink its balance sheet.

The Markets Want Your Money. Don't Give It to Them.(Smart Contrarian)

Feb 9, 2018

MFs are having a gala time taking money from over-eager investors and funneling it into equities. Smart investors, though, know better than to do that.

The Big Gamble(The Honest Truth)

Feb 15, 2018

Once you accept the fact that elections are round the corner and that this budget is geared to reach a 40% target, everything makes sense.

NPAs Set to Rise Further with New RBI Rules(Chart Of The Day)

Feb 15, 2018

The RBI overhauls bad loan framework. Banks may come under additional pressure due to rising NPAs and increased provisioning.

More

Small Investments
BIG Returns

Zero To Millions Guide 2018
Get our special report, Zero To Millions
(2018 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Feb 22, 2018 (Close)

MARKET STATS