India: Is the Interest Rate Cycle Beginning to take an Upturn?


D Tripati Rao

The Annual Monetary Policy Statement 2005-06 contains little that is new. Monetary measures remained unchanged except for the reverse repo rate (the agreed price between two parties for the repurchasing of a security) being increased by 25 basis points. The bank rate and the repo rate (agreed price between two parties for the selling of a security) have been left untouched. Singing the signature tune of 'price stability', the monetary policy stance has been given a barely perceptible shift in emphasis from 'adequate' to 'appropriate' liquidity at a time when industrial growth is finally picking up and non-food credit is witnessing a record peak growth, the highest in 55 years. Interestingly, the monetary authority has given a signal of its intent to play a more benign role in the economy, moving away from an 'accommodative' to a more 'neutral' role.

Central banks are notorious for spoiling the 'private party' going in full swing. Acting on the basis of their considered judgment, they usually pull the levers even before reaching cyclical peaks. While recognizing the excess liquidity overhang, strong credit growth, incomplete pass-through of the oil price shock and its attendant uncertainties and the firming of primary commodity prices in international markets, the Reserve Bank of India has not taken any direct measures to impede liquidity flow. By its own admonishment, the RBI is acutely aware that the government's budgeted market borrowing for this year of Rs110291 Crore is three times that of the previous year. Of course, it has tacitly signaled that the downward trend in domestic interest rates has petered out. What, then, is an appropriate level of interest rates given the macroeconomic fundamentals?

The nominal rate of interest in the long run is expected to be equal to some 'equilibrium' or 'natural' real rate of interest plus an adjustment for the expected long-term inflation and risk premium. Interest rates in India moved upwards soon after deregulation in the early 90s. Major macroeconomic aggregates - GDP growth and industrial production - were quite impressive in the early 90s even while the interest rates were overshooting. Expressing a growing concern, the monetary authority created a conducive environment for the sharp downward revision of interest rates since 1997-98. But the lowering of interest rates has not really helped to achieve any remarkable performance in intermediate or ultimate goal variables. In fact, growth rates of the GDP, industrial production and investment have declined during this period. The underlying reason appears to be that investment in India primarily works via an accelerator mechanism, which in turn mostly depends on consumer and government demand. All that the low interest rate regime did was to feed the unending government appetite for market borrowing. Being a relatively weak supply constraining factor, the interest rate has played a minimal role in India during the period of the low interest rate regime because of the existence of twin traps - the liquidity trap and the investment trap. The growth rates of savings, bank deposits, and also net capital inflows declined during the low interest rate regime period, which resulted in an increase in demand for consumer durables, precious metals, physical assets (real estate) and also helped to generate black (undeclared, untaxed) income.

Interest rate policy has a legitimate role to play in helping to achieve the developmental objectives of social justice and equality. For a positive and reasonable real rate of return for the millions of small savers - old and retired pensioners constituting the mainstay of national savings - the recent increase in price levels by 7.94 per cent should force an upward movement in the interest rate. A substantial reduction in interest rates on bank deposits, small savings, provident funds, and other debt instruments has already resulted in a decline in the interest income of this section of the community by 50 to 60 per cent in the recent past. On the other hand, investment in equities and units enjoy many comparative advantages, with substantial fiscal concessions and incentives.

Thus, the evidence suggests that a downward interest rate cycle is petering out and that we are about to enter a pro-cyclical upturn in interest rates. Complex domestic macroeconomic forces, including the budgeted massive market borrowing programme and dependency on a good monsoon; domestic credit demand; an upward movement in the inflation rate (which may increase further with the recent announcement of an upward correction in domestic oil prices); and, external developments such as the stabilization of international crude oil prices at a higher level and an upward movement in world interest rates and prices (to the extent that this is passed through to the domestic economy) are factors fuelling pressure on interest rates. Inevitably, a willingness to pay market-determined and risk-related interest rates will become the social and moral responsibility of the corporate sector.

WATCHPOINT: To the extent that an upward correction in domestic oil prices, the government's market borrowing as well as sustained credit demand compounds to generate higher inflationary expectations, one would expect an interest rate increase to be looming on the horizon.


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