Dr Ashwani Mahajan
New RBI governor, Urjit Patel, while announcing his first Monetary Policy Review, reduced Repo Rate by 25 points to 6.25 percent. This has given a pleasant surprise to the market. General feeling was that Urjit Patel concurred with his predecessor Raghu Ram Rajan about not generally reducing interest rates. Therefore, this step of Urjit Patel has brought cheer to the market and economy at large. It is understandable that with reduction in interest rates, cost of borrowing would go down; and that would encourage investment in both industry and infrastructure. With lower interest rates, it becomes easier to purchase houses, cars and other consumer durables, as EMI on loans gets reduced. Though it is true that this small increase in repo rate is not going to make any significant impact on EMI; however if we look at falling repo rate since 2014, the cumulative impact is really sizable. Why Urjit Patel’s endeavour in his latest monetary policy review is important, because with that he has tried to distance himself from the legacy of Raghu Ram Rajan and his impression as ‘inflation howk’. About Raghuram Rajan’s monetary policy, not only the market and the government, even experts believed that he was ‘too adamant’ about keeping interest rates high. When Raghuram Rajan took over as RBI governor, at that point, wholesale price index was used as an indicator of target inflation, which was changed to consumer price index, on the recommendations of the committee under the chairmanship of Urjit Patel. As a result, though wholesale price index continued to show near zero rate of inflation, Rajan refused to reduce interest rates, with the argument that consumer inflation was still high at 5 percent. Therefore when Urjit Patel chose to reduce repo rate, despite the fact that, there was no reprieve in consumer price index, experts were surprised.
High Interest Rate Policy: Not Good
Past governor, Raghuram Rajan used to give various arguments for high interest rate regime. His first argument was that interest rates are required to be kept high to maintain reasonable real rate of interest, given that, real rate of interest is money rate of interest minus rate of inflation. His second argument was that if we reduce interest rates, then foreign investors may shift their investments abroad. His third major argument was that if we reduce interest rates, it may induce more demand, causing worsening of inflation. Notwithstanding his arguments, this is equally true that due to high interest rates, our GDP growth was badly affected. If we look at the GDP data in the past few years, hiking of interest rates coincided with slowing down of growth. It is notable that when repo rate was 5 percent in 2010-11, our GDP growth rate was 8.9 percent which declined to 6.7 percent and 4.7 percent during 2011-12 and 2012-13 respectively, when repo rate increased gradually to 8.5 percent. Now since 2013-14 till date, when repo rate declined gradually to 6.25 percent now, GDP growth reached 7.6 percent in 2015-16 and is expected to reach 8.0 percent in 2016-17.
According to a research published by Gordon in 1975, if inflation is caused by supply shocks, monetary policy of high interest rates to control inflation is not a right policy. This is because increase in interest rates leads to further fall in production, as not only private, even public investment is badly hit. It is notable that in the recent past inflation was primarily due to inadequate increase in agricultural output. During 2012-13 agriculture growth was hardly 0.9 percent; in 2013-14, it improved to 3.7 percent, before falling to 1.1 percent in 2014-15. That is, average agriculture growth remained less than 2.0 percent during three years between 2012-13 and 2014-15. Thus inflation in India has primarily been caused by food inflations, and therefore constantly rising interest rates caused furthering of slowdown in non-agriculture sector. Thus we can conclude that high interest rates affected our growth adversely in the last few years.
We need to keep in mind that in developed world, interest rates are near zero. Under these circumstances keeping interest rates high in India, causes high cost of borrowing and therefore high cost of production, which affects our competitiveness adversely and nation may fall behind the world in competition. Therefore, this act of Urjit Patel may spur growth. We can except that with increase in growth prices may also be under control, which may help reducing interest rates further.
Other Challenges for Urjit Patel
For the first time, there will be a Monetary Policy Committee, which would determine interest rates in the country, bidding farewell to the monopoly of the RBI governor in this regard. Recently, government has nominated its representatives for Monetary Policy Committee. Therefore, it would be imperative for Urjit Patel to work in coordination with the Monetary Policy Committee. Another challenge for Urjit Patel is to address the ever deteriorating problem of Non Performing Assets (NPAs) of the banking system. His yet another challenge would be to strengthen the rupee which has generally been weakening in the past. Though exporters continue to put pressure for devaluation of rupee, in their self interest, however, rupee needs to be strengthened for various reasons. For not allowing rupee to depreciate and gradually become stronger, role of RBI is very important in keeping vigil over foreign exchange position and market forces. Another challenge for Urjit Patel would be to deal with NRI deposits worth nearly US$30 billion, and to re-attract them. Public sector banks have been facing tough competition from the private sector banks, especially due to technological superiority of private sector banks. Equipping public sector banks with latest technology would be another challenge for Urjit Patel.
(The author is Associate Professor, PGDAV College, University of Delhi)
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