Why policymakers need to rethink: Hiking interest rate to control demand no help

What we are witnessing today is in reaction to Reserve Bank of India (RBI) raising its repo and reverse repo rates. Since September 2004, these have gone up by 125 and 150 basis points to 7.5 per cent and 6 per cent, respectively. Simultaneously, cash reserve ratio (CRR) has risen by 100 basis points to 6 per cent, risk weights for housing loans have been increased from 50 per cent to 75 per cent, commercial real estate from 100 per cent to 150 per cent and consumer credit from 100 per cent to 125 per cent.

While increased interest rates have raised the cost of money in the economy, higher CRR has sucked liquidity out of the system, adding to financial stress. While this doesn’t hurt big companies which can raise money from global financial markets at attractive rates, it has put pressure on smaller companies and entrepreneurs. And of course, on the aam admi wanting to buy a house, a car or a consumer durable.

True, inflation of goods and services as well as of asset prices like houses, is a concern, both economic and political, and RBI’s response has been in tune with finance ministry’s moves. But when the issue is one of supply constraints, curbing demand becomes an exercise in futility. The cost of money in the economy has increased, while the policy response to inflation should have been to enable an increase in supply.

Says, Rajeev Kumar, chairman and CEO, ICRIER: “The rise in interest rate is an effort to dampen demand.” In other words, the rise in interest rates is a move to bridge a gap created by the inefficiencies from the supply side. This is obviously not fair for end users of a growing economy, he says.

The country has been facing stiff supply constraints which has led to a situation, where inflation has shot up and a need to control the demand has risen, says Kumar. “To improve the supply side will require at least six months to a year. It is a long process and needs reforms whereas inflation needs to be checked on an immediate basis.” The answer he feels could lie across the border. “The government should learn from China,” says Kumar, “as how it has managed to grow at 10 per cent for two decades with inflation of less than 2 per cent. The government should take steps and do whatever it can to find how China has done it.”

Why stop at China? If the world is the benchmark for prices, interest rates and inflation, let’s see what’s happening across the globe. For the past eight months, there has been no revision in US federal funds rate (fed rate), but RBI has raised its repo rate thrice to take it from 6.5 per cent to 7.5 per cent. If we compare the past five years’ movement of repo rate and commercial banks’ prime lending rate (PLR) with the fed rate, the trend matches till 2004 when both were moving down. Since then the fed rate started rising and moved from 1 per cent in May 2004 to 5.25 per cent in June 2006, whereas RBI’s repo rates were stable till October 2005 at 6 per cent and only started moving up after that, a process that has not yet ended.

Says, Abheek Barua, chief economist, ABN AMRO Bank: “This is because of countries being at different points of economic cycle at one time. Our business cycles are not synchronised. The US economy started overheating much before ours and started slowing down in mid-2006. The Indian economy showed signs of overheating a little later and hence the responses by Federal Reserve Bank and RBI has been different at different points of time.”

But in end-2005 when RBI started its trend of raising the repo rate, bankers and economists had said it was to control excess liquidity in the market – there was too much money chasing too few goods and raising prices; hence by controlling money supply prices would fall. Another point being made was that globally central banks had been raising interest rates to control prices of all asset classes that were on an upward trajectory and so RBI’s response is no different.

Actually, there are two differences: time and supply. Across the world, this control didn’t have to last very long, as prices through increased supply pipelines and hence interest rates stabilised in the developed world. In India, however, the rate increase is on with almost no relationship to global factors. The rising interest rates seems to be here for now. “The inflation figure was slightly higher than expected for the last week and there is a possibility that RBI might increase interest rates again in the next credit appraisal meet,” says Barua. If rates rise again, commercial banks will follow.

But if taming inflation is really where energies of the government are focussed today, it should be looking at increasing supply — of foodgrain and commodities by imports or capacity building, and property by opening up more land for development. Raising interest rates will only serve to increase the cost of money for smaller entrepreneurs and households, and hampering the other desirable the economy is getting used to: high growth.

If inflation is the enemy, supply is the friend — not increased interest rates. It is this message that policymakers need to understand and execute.