Betwixt Ideology and Theory: Financial Express: 9th January 2008

The finance minister’s statement asking banks to lower their interest rates is significant for two reasons: one, ideological, and the other, theoretical. The finance ministry is the overseer of the RBI, which is the monetary authority, and to that extent expects obeisance from the latter. The ministry is also responsible for the Budget, by which the government plans its revenue and expenditure. The ministry, hence, is affected by movements in interest rates as they affect its own arithmetic. It is in the ministry’s interest that the RBI has appropriate policies in place that are justified as being necessary to support investment and growth.
The ideological issue to be addressed is the distinct conflict of interest between fiscal and monetary policies, where it appears that fiscal policy takes precedence by virtue of the regulatory hierarchy. The FM’s statement, therefore, is important. It comes four weeks before the credit policy is to be announced, while the Budget would be in another eight weeks. In the past, too, FMs have dropped similar hints after announcing the Budget, saying, for example, that the RBI would have to follow up with appropriate measures in the credit policy statement that comes two months after the Budget.
The FM’s exhortation to banks to lower interest rates can thus be seen as a mild directive to the RBI to see this through. While the FM’s statement could be perceived as being appropriate from the point of view of spurring investment and growth, it can also be interpreted as a ministerial imposition on the RBI. After all, banks lower interest rates when policy rates are changed by the RBI, and announcements on this are the central bank’s prerogative; while it is true that interest rates are determined by banks on their own ever since they were deregulated in the mid-1990s, the RBI’s policy rate changes have a strong bearing on any such action. An increase in CRR or the reverse repo rate, for example, tends to increase interest rate levels in the country. On the other hand, the FM has to also take a position on interest rates, and hence runs an interpretation risk whenever such statements are issued.
An independent and autonomous central bank could be the solution here. But this is a difficult decision for the government to take, considering that across the world there is this conflict which has not been resolved, with governments invariably preferring to have their say in monetary policy formulation.
The practical aspect of this view has more economics to it in evaluating whether or not a cut in interest rates is really desirable in the current situation. The theoretical function of interest rates is to address the twin objectives of growth and stability. Lower interest rates are associated with growth, while higher interest rates are directly connected with stability. The Indian Economy’s current growth is poised at a robust level of around 9%, notwithstanding the level of interest rates, which is steady. Lower interest rates would encourage spending (that is, both consumption and investment). However, banks have become a bit more cautious with their lending operations following the US subprime crisis, and have taken a conservative approach to retail loans. Retail loans, especially mortgages and credit cards, were two leading sectors in the credit profile of banks that were responsible for the explosion in credit growth last year. While the cost of funds does matter, banks have also been more vigilant. Therefore, they have preferred to channel their funds to government securities.
In the first nine months of the year, while deposits have grown by 12.8% (11.2% last year), credit has increased by 10% (15.2%) and investments by 18.9% (4.7%). This has been aided by the issuance of MSS bonds necessitated by excess capital inflows. There is, therefore, reason to believe that growth is buoyant and that the cost of funds has not been a limiting factor. Also, in bull market phases, as observed by analysts, interest rates tend not to constrain investment activity.
Now, let us turn to inflation. Inflation is low at below 4%, which is fair enough. However, the ministry of petroleum is talking of raising the prices of petroleum products. Prices of manufactured goods are looking up, as are those of primary products. Overall inflation could soon be higher than the placid 3.5% rate we are witnessing presently. And for monetary policy to be effective, as it operates with a time lag, the RBI must look at expected inflation rather than current inflation. Any reduction in interest rates would have to be deferred till there is clarity on future prices. Also, with elections coming up in 2009, the next financial year will be critical from the point of view of inflation.
To conclude, no lowering of interest rates is required right now, as the present levels are consistent with the objectives of high growth of around 9% and stable inflation of below 4%. But the answer to the question of whether interest rates be lowered later this month by the RBI, is a probable yes. Seldom do FM’s requests go unanswered.