Hike in Policy Interest Rate: It’s All Elementary!

As is obvious, in a climate where the WPI-based inflation rose in September for the fourth successive month to about 6.5 per cent, which is indeed expected to rise further owing to the likely rise in food and fuel prices, the  Reserve Bank of India (RBI) has rightly raised its key Repo rate by 25 basis points to 7.75, up from 7.5 per cent, to anchor inflationary expectations while simultaneously bringing down the interest rate under Marginal Standing Facility by an equal 25 basis points to 8.75 from the current 9 per cent to ease liquidity constraints in the banking system.

The RBI must be congratulated for being realistic in its review of the economy as also for coming up with balanced monetary measures to manage the economy. It has also left no illusion in the minds of people about the likely growth rate of the economy in the 2014 fiscal by lowering the growth in GDP to 5 per cent from the previously announced growth rate of 5.5 percent.      

  

Reacting to the rise in Repo rate, the Director General of the CII lamented: “Industry is already reeling under the pressures of high cost of capital and low availability in a tight liquidity situation” and amidst such a scenario, “raising interest rates will hurt growth while proving unequal to the task of tackling inflation”.  Echoing a similar discomfort, Naina Lal Kidwai, president of the Federation of Chambers of Commerce and Industry, said that the high cost of capital resulted from the hike in interest rate by the RBI made Indian companies less competitive in the global arena. 

In a scenario where retail-inflation is likely to remain around 9 per cent in the days ahead, the RBI, perhaps, has no option but to raise the key policy rate. Indeed, the RBI governor has clarified the intention behind the policy decision thus:  “You should not see the fight against inflation as anti-growth; it is going to be the best medicine for sustainable growth going forward.” He went on to say that the rise in interest rate is meant to “curb mounting inflationary pressures and manage inflation expectations”, that too, “in a situation  of weak growth” and thereby “strengthen the environment for growth by fostering macroeconomic and financial stability.” 

There is another interesting observation made by Mr. Rajan, governor, RBI, that merits industry’s attention particularly, that of banking sector: the current rise in interest rate is unavoidable, for “it is important to break the spiral of rising prices in order to curb the erosion of financial savings and strengthen the foundation of growth.” To maintain the confidence in the value of rupee, the governor had no option but to ensure that the rate of growth of money and credit “is not out of line with the increase in real output.”  

As against this, the industry argues that today’s inflation is more out of supply side constraints as is experienced under food and fuel prices and hence they aver that merely raising Repo rate by RBI cannot bring down the prices of onion or other food items. Secondly, they argue that in an over-heated economy, the conventional monetary policy tools might work to bring down prices but not in an economy that is in slowdown mode.  There is, of course, a merit in their argument. But once we take into cognizance the fall in our domestic savings and the widening current account deficit that resulted in the free fall of rupee vis-à-vis dollar as was witnessed in August, the need for raising policy interest rate by the RBI becomes apparent. 

One should not get carried away by the absence of the inter- and intra-day variations in the exchange rate that is being experienced now, for it is not by virtue of any improvement in the intrinsic value of the Rupee. Thanks to the innovative policies of the RBI such as opening of a separate window for oil companies to buy their dollar requirements directly from the RBI and offering a special swap arrangement to commercial banks for the foreign capital mobilized by them that obviated volatility in the Forex market besides, of course, strengthening the rupee.  However, as the RBI has partially withdrawn this facility offered to oil companies, the market is again witnessing a fall in rupee price for the last two to three days. 

It is good of RBI that it made matters so clear when it said: “Despite the recent exchange-rate stability, the external environment for the country is still fragile.” That being the reality, growth or no growth, pressure or no pressure from the FM, the Central bank cannot but take a serious view of inflation. And the need for such decisive action is all the more essential in periods of weak industrial growth as otherwise raising inflation can tilt the balance adversely. 

That being the reality, if we are to be ready for facing the tapering policy of quantitative expansion of Fed Reserve which is expected to be operative from the first quarter of 2014, we must pull up our strings to make rupee strong. So, the immediate need of the hour is to pave the way for increasing domestic savings. Which is why, the banking industry must come out with such products and services which can offer better returns to the savers. In this regard, the proposed retail inflation-indexed security must be made saver-friendly; else, it may not attract any participation from the prospective savers. 

Given the conundrum that we are facing, there is no wonder if the RBI continues its battle against inflation into next quarter too, for no short-term tinkering will lead to sustainable growth, nor would it create right atmosphere for the inflow of foreign capital. So, the industry, instead of cribbing at the Central bank for raising policy interest rate, must learn to innovate how to absorb the increase in capital costs and remain competitive in the global markets.