X

Sign up for Equitymaster's free daily newsletter, The 5 Minute WrapUp and get access to our latest Multibagger guide (2017 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
 
 
RBI's finest hour is yet to come

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

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.

You've Heard of Timeless Books... Ever Heard of Timeless Stocks? (The 5 Minute Wrapup)

Aug 19, 2017

Ever heard of Lindy Effect? Find out how you can use it to pick timeless stocks.

Why NOW Is the WORST Time for Index Investing (The 5 Minute Wrapup)

Aug 18, 2017

Buying the index now will hardly help make money in stocks even in ten years.

Trump Takes a Beating (Vivek Kaul's Diary)

Aug 18, 2017

Donald J Trump, a wrasslin' fan, took a 'Holy Sh*t!' blow on Tuesday.

How To Read Your Mutual Fund Account Statement Correctly (Outside View)

Aug 17, 2017

PersonalFN simplifies the mutual fund account statement for you.

More Views on News

Most Popular

Demonetisation Barely Made Any Difference to Tax Collections(Vivek Kaul's Diary)

Aug 7, 2017

The data tells us quite a different story from the one the government is trying to project.

A 'Backdoor' to Multibaggers: It's Like Investing in Asian Paints Ten Years Ago(The 5 Minute Wrapup)

Aug 10, 2017

Don't miss these proxy bets on growing companies or in a few years you will be looking back with regret.

Should You Invest In Bharat-22 ETF? Know Here...(Outside View)

Aug 8, 2017

Bharat-22 is one of the most diverse ETFs offered so far by the Government. Know here if you should invest...

Signs of Life in the India VIX(Daily Profit Hunter)

Aug 12, 2017

The India VIX is up 36% in the last week. Fear has gone up but is still low by historical standards.

7 Financial Gifts For Your Sister This Raksha Bandhan(Outside View)

Aug 7, 2017

Raksha Bandhan signifies the brother-sister bond. Here are 7 thoughtful financial gifts for sisters...

More
 

Become A Smarter Investor In
Just 5 Minutes

Multibagger Stocks Guide 2017
Get our special report, Multibagger Stocks Guide (2017 Edition) Now!
We will never sell or rent your email id.
Please read our Terms

S&P BSE SENSEX


Aug 18, 2017 (Close)

MARKET STATS