RBI governor’s decision to refrain from a rate hike has been the most impressive one since he took charge. It is significant for being contrary to the popular opinion. The hike in interest rate was expected as inflation has been stubbornly high. Let us understand why it makes a lot of sense despite high inflation and desperate need to tame it.
The primary contributor to price rise is food inflation which has been in double digits for 20 months now. The Achilles heel is vegetable prices, hurting the common man. The other large contributor to inflation has been fuel prices. Yet, the fact is RBI’s monetary policy can achieve nothing as far as food, vegetables or fuel prices are concerned.
The point is driven home beyond doubt if we take the case of onions as an example. When onion prices skyrocket, it becomes a huge political issue. How people forget that a few years back when onion prices had crashed to 50 paise a kilo, many farmers in Vidarbha had committed suicide. If RBI is expected to address the issue of rising vegetable prices, one would suppose it would apply itself to the issue of havoc caused by low prices as well. If rate hike could help prices to come down, the corollary is aggressive rate cuts would have helped onion prices to soar. The real causes of problems are different. As a nation, we have failed to invest in productivity improvement and in creating infrastructure for cold storage and logistics chain to handle the temporary glut and shortages. The farmers or consumers suffer as the product is perishable and demand is inelastic. Similarly, no one expects RBI policies to impact global crude prices, which, in turn, influence petroleum products prices.
Why do we try to have the right solution for a wrong problem? For commodities that have supply constraints and demand is relatively inelastic, response to traditional monetary remedy is opposite of what is expected. The way Griffin’s goods respond to demand-supply forces. It is counterproductive for two reasons. One, cost push inflation as interest is a key cost component. Two, high interest rates deter capacity creation and expansion, exacerbating the medium-term shortages.
RBI raised the policy rates 13 times in 18 months in 2010-11, and twice in 2013, with no success in the stated objective of controlling inflation. There has been a huge collateral damage. The high interest rates have slowed down investment in new capacity creation and, therefore, the pace of job creation as well. This is a dangerous situation for a nation adding 15 million people to workforce every year. One would ask what is accounting for credit growth. The reality is: it is working capital or recycling of earlier loans with interest. Further, high interest rates have exacerbated the debt burden of companies passing through a difficult phase for reasons of stalled projects, unclear policy framework or down cycle. The banks are looking at bigger than ever before specter of bad assets. As we have seen recently, the policy rate changes are not getting transmitted to the deposit or lending rates of banks. There are overriding factors of liquidity, margins and demand-supply for funds. The impact nonetheless is there on the sentiment of businessmen as well as equity investors. Whether we like it or not, sentiment plays an important role in the revival of real economy as well. An entrepreneur’s decision to take the risk of new projects and expansion is driven by sentiment.
We all know equity, debt as well as currency markets are driven by sentiments. To meet our current deficit, equity can be a lot more effective instrument than debt, for attracting foreign capital. That, in turn, can stabilise longer end of interest curve and bring stability in money market as well. The governor’s inaugural speech changed the sentiment and course of foreign exchange, equity as well as debt markets. This has come at an appropriate time as business confidence was again sinking. I think it is based on the correct assessment of the situation, although it is against the sentiment of the crowd. Max Lucado put it well ‘A man who wants to lead the orchestra, must turn his back on the crowd’.
The above column appeared in the Economic Times dated December 19, 2013