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.
Common concerns: Monetary, Exchange and Gold Policies - Outside View by S.S. TARAPORE
  • MyStocks


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

Common concerns: Monetary, Exchange and Gold Policies
Jun 1, 2015

All eyes are on Governor Raghuram G.Rajan's second monetary policy review for 2015-16 on June 2, 2015. With the agreement between Government and the Reserve Bank of India ( RBI) of February 22, 2015 on flexible inflation targeting, an erroneous view is being articulated that monetary policy has been simplified in that as inflation falls, the RBI policy repo rate ( i.e. the repo rate at which the RBI lends to banks against the collateral of government securities) can be reduced. This is not so simple. For instance, monetary policy impinges on capital flows and the exchange rate as also mobilisation of gold hoards.

Implications of Policy Interest Rate Changes

Monetary policy has a long transmission lag of 18-24 months and, as such, too frequent policy interest rate changes are not feasible. While lowering of policy interest rates is welcomed by borrowers, who have greater clout, this adversely affects depositors who have less bargaining power. Per contra, when policy interest rates are raised, depositors welcome the move but borrowers resist upward movement of interest rates. When the RBI alters policy interest rates it has to take a considered judgement on the medium-term inflation rate. The interest rates have to be assessed on the basis of real interest rates i.e. the nominal rate minus inflation.

Influential policymakers sometimes talk in terms of a real rate of interest of 1.5-2.0 per cent as being adequate to reward savers. The appropriate real rate of interest has to be considered against the backdrop of the real rate of growth. If the real rate of interest is higher than the real rate of growth, the economy would slow down. Given that there is a myriad of lending and deposit rates it is important to focus on which indicator of interest rates should be used to judge the appropriateness of the policy interest rate. The whole exercise is complicated by the fact that large borrowers are able to obtain credit at lower interest rates, ostensibly because they are perceived as being more creditworthy than small borrowers. There is irrefutable evidence to suggest that delinquency cuts equally across both large and small borrowers. Thus, the RBI has to take a well considered call while deciding on the appropriate policy interest rate

Again, the RBI has to give attention to the phase of the trade cycle. If the policy objective is to keep the growth rate close to the ceiling of growth, then monetary tightening needs to be taken early during the uptrend of the cycle of growth. Popular perception is that by tightening during the uptrend of growth, the RBI is a ‘spoil sport'. Thus, there are tensions whenever policy interest rates have to be altered.

Exchange Rates and Competitiveness

Monetary policy and exchange rate policy cannot be kept separate and distinct. Given that capital inflows and outflows impinge on monetary expansion/ contraction, the two policies have to be closely coordinated.

All along there has been a major aberration in macroeconomic policy in India. The Indian polity's policy preference is for a strong rupee exchange rate. For a competitive exchange rate we need to take cognisance of the inflation rate differentials between India and major trading partners. The RBI's six-country trade weighted real effective exchange rate shows an appreciation of 25 per cent in April 2015. It is heartening that Dr. Arvind Subramaniun, the Chief Economic Adviser, Ministry of Finance, has categorically stated that our over-valued exchange rate is damaging the economy. One fervently hopes that the powers that be will listen to its top policy adviser and that this major flaw in policy will be corrected. A back of envelope calculation would indicate that the nominal exchange rate of the rupee would need to depreciate from US $ 1=Rs 64 to a rate somewhere between US $ 1= Rs 70-75. Pending this aberration being rectified it would be hazardous to lower the policy interest rate.

Gold and Interest Rates

After much deliberation the Government of India has set out the Draft Rules for various schemes for mobilising domestic hoards of gold. As regards the Gold Deposit Scheme, some modifications of the proposed scheme could result in a significant increase in the amount of domestic hoards of gold being mobilised. Unlike the unproductive 1993 scheme wherein a rate of return of 2 per cent, in gold, was offered and the gold merely kept in the RBI vaults till redemption, the proposed new scheme would be more purposeful.

It is suggested that the Gold Deposit Scheme should be restricted to primary gold and not jewellery. The rate of interest on these deposits is to be determined by individual banks as proposed in the draft rules; it is reliably gathered that banks are likely to offer only 1.0-1.5 per cent on such gold deposits. Such a low rate of return would result in a sure failure of the scheme. While banks can determine the rate of interest offered, there should be a minimum return of 4 per cent. At this rate of return, large hoards would be mobilised. While the minimum return on gold deposits appears to be high, banks would easily be able to charge a rate of say 8 per cent on lending to users of gold. This would be a sure way to reduce gold imports. This would be one more reason to defer any reduction of policy interest rates while the gold mobilisation scheme is being launched.

It is unrealistic to expect holders of jewellery to offer their gold under the Gold Deposit Scheme. It would be better to encourage banks to give gold loans (with appropriate margins), subject to a ceiling rate of interest on these gold loans of 16 per cent. At present goldsmiths provide credit against jewellery at a rate of 24 per cent per annum. As banks gold loans increase, the ceiling rate of interest on gold loans could be lowered. Purists could argue that prescribing rates of interest on lending and deposits would be a reversion to the diktat regime but there could be a trade off for mobilisiing large gold hoards. The KUB Rao Working Group deserves kudos for having conceptualised a scheme to mobilise domestic hoards of gold.

Note: This article was first published in The Freepress Journal on June 01, 2015. 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.

Equitymaster requests your view! Post a comment on "Common concerns: Monetary, Exchange and Gold Policies". Click here!


More Views on News

Insider Leaks Equitymaster Stock Picks (The 5 Minute Wrapup)

Jul 25, 2017

Equitymaster HQ has been infiltrated. Valuable stock ideas have been leaked. Who's responsible?

Raymond and Other 'For Profit' Companies Who Don't Care about Shareholder Returns (The 5 Minute Wrapup)

May 27, 2017

What happens when minority shareholders are short-changed in the normal course of business?

Why Commission Driven Model In Mutual Funds Should Be Eliminated... (Outside View)

Feb 15, 2017

PersonalFN believes SEBI has taken a step back-apparently in the admission of it going overboard with the regulations.

This Book Changed How I Looked at the World of Man and Money (Vivek Kaul's Diary)

Aug 24, 2016

And here's your chance to claim a free copy of this book...

The Developed World is Dying because of Demographics, Debt, and Deflation (Vivek Kaul's Diary)

Aug 12, 2016

And Why India's demographic dividend could turn out to be a doubtful debt...

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.

India's Rs 1,66,276 Crore Problem(Vivek Kaul's Diary)

Feb 15, 2018

That's the loss, the government owned public sector enterprises are expected to make this year.

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.

How I Beat the Index by 2x... And Why I Believe This Could Happen Again(Smart Contrarian)

Feb 12, 2018

Will Microcap Millionaires be able to replicate its past performance of beating the index by 2x?

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.


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