Will the RBI rate hike help calm inflation?

November 4, 2010

(D. H. Pai Panandiker is President of RPG Foundation. The views expressed in this column are his own and do not represent those of Reuters)

The Reserve Bank of India (RBI), almost unwillingly, increased the repo and reverse-repo rates by 25 bps on Nov 2. The central bank was more concerned about continued high inflation than the likely squeeze in industrial growth that could be caused by higher rates.

In the last one year, the RBI has tried almost every trick in its bag though without much success. The present fine tuning of the credit policy is another attempt to calm inflation and may not have a different outcome.

During this year, the repo-rates were increased five times in baby steps of 25 bps. However, the headline inflation did not reverse. That was good enough to indicate the present inflation is eitherinsensitive to interest rates or would take a long time to take its toll.

Interest payments are a significant part of profits before tax (PBIDT). The interest payments/PBIDT ratio in the manufacturing sector increased from 12 percent in the quarter ending June to 18 percent in the quarter ending Sept 2010. During this time the interest on bank credit had increased by 1 percent.

Clearly an increase in interest rates erodes profitability which can seriously depress investment and growth.

The other effect of the increase in rates comes from the induced fall in demand for consumer goods. Two in particular are important. First, interest is an important component of home prices when these are purchased on credit. In addition to the increase in repo rate, the RBI has also capped home loans at 80 percent of the value of property and increased provisioning for teaser loans to 2 percent.

The bias against teaser rates is mainly because these led to the housing crisis in the U.S. which precipitated the financial crisis worldwide. But that was not so much because of the teaser rates as their abuse by the financing agencies.

Second, loans against automobiles are equally sensitive to interest rates. At present, the demand for automobiles is high but an increase in rates by commercial banks will very much weigh down on this trend.

The real concern is food inflation which is totally outside the scope of credit policy. It now appears that food inflation is not merely an offshoot of the failure of the monsoon last year. Rather, food prices the world over have been rising and are likely to rise in the future.

Indian agriculture, like in many other countries, had been starved of investment for a long time and even good monsoons, by themselves, cannot raise production to match growing demand from expanding population and improving incomes.

The present inflation is a complex of short-term and long-term problems. A complete solution to inflation is beyond the scope of RBI’s credit policy. That solution has to come mainly from the budgets of the central and the state governments by allocating funds for major investment programmes in agriculture.

Obviously, the increase in the repo rate which has been undertaken on Nov 2 is not likely to make much difference to inflation but may subdue industrial growth.

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