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

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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.


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