Time to think beyond monetary policy rates?

June 17, 2012

(Rajan Ghotgalkar is Managing Director of Principal Pnb Asset Management Company. The views expressed in this column are his own and do not represent those of either Principal Pnb or Reuters)

Irrespective of the RBI monetary policy review and its outcome, the fact that policy rates have assumed such obsessive focus needs closer scrutiny.

The boom from 2003 to 2008 was not peculiar to India, which like other emerging countries benefited from the liquidity surplus in developed economies and capex into capacity building was at its best. The Indian economy was already overheated when it collapsed from the sudden credit shock following the Lehman event.

The massive government spending, which incidentally had commenced even before the 2009 crisis, ensured a rapid recovery peaking the economic cycle on the back of consumption.

A shortfall in supply capacities eventually led to the decline with food, particularly protein, inflation racing off.

The monetary policy rate hikes had no significant impact on food prices. This time the government, unlike in 2009, has little fiscal capacity to boost spending and a reduction in interest rates is more likely to prove a mere symbolic gesture.

The consistently negative real interest rates have only pushed Indian savers into gold, our asset class of cultural preference; pushing the trade deficit to historical highs. The global economic situation fuelled by rupee weakness due to the twin deficits, resulted in its devaluation. India being a net importer by virtue of oil pays for devaluations through inflation.

It is unlikely that oil prices will stay suppressed all along. The combined impact on inflation especially if the U.S. Fed goes in for QE3 can prove hugely challenging.

A reduction in interest rates with an intention to push consumer durables would not help in our battle against inflation.

Our challenge will remain to simultaneously restrain inflation, restore the saver’s confidence in the financial economy and tightly direct investments into infrastructure building.

The presidential election process has brought out the gaps in the ruling coalition. It seems unlikely that there will be significant structural solutions forthcoming till the elections. Further with regional parties gaining prominence at the expense of national parties, core policymaking may remain a challenge even in the next parliament term. Withdrawal of subsidies, reduction in government expenditure and control on welfare schemes may not be easy and fiscal deficits may remain a bother.

The solution possibly lies in making subsidised credit available to infrastructure and production capacity enhancement in a directed manner.

This along with ensuring positive real interest rates for savers will revive their faith in financial assets and promote savings.

Consistent negative real rates paid to savers is almost like getting them to subsidise the borrowings to businesses. A surcharge of sorts, especially when they may not even get the benefits. Senior and retired citizens have already been shut off by the equity markets and now their hard-earned money too will soon be rendered worthless.

Therefore, one would rather accept our political frailties and push at the supply end, as it is more likely to give better results than merely bringing down broad-based policy rates.

We can only depend on growth rates to amortise our fiscal deficit. However, a lower growth rate of say 7 pct may have to be the norm unless we can also simultaneously complete initiatives to ensure the subsidies reach the deserving; whilst we continue struggling for the political consensus required to push through the broad-based reform agenda.

The S&P report mentions “these recent developments are not serious enough to lower the sovereign’s creditworthiness”. It goes on to say that, they will consider a downgrade if the government’s policy response to challenges is too little or too late. It is concerned that the government may further regulate the economy to reduce short-term threats to the economy.

There is no point in getting defensive. Just as we happily lapped up earlier praise from rating agencies; it may be worth closely examining their suggestions for a longer term structural outlook.

At the same time we cannot continue to blame our plight on global factors as there is a lot we can do within.

India’s long term growth story is, of course, intact but has exhausted the benefits of the 1990s dose in liberalisation.

I believe we may well have seen the worst but it’s time for a fresh booster so that 2013 can see our economy back to the 7 pct to 7.5 pct growth range.

The solution may not be in taking to knee-jerk and extortionist fiscal actions but rather recognising the need to protect our creditworthiness so that we can attract enough FDI to replace the FII hot money and impart stability to the rupee.

As Einstein said “doing the same thing again and again expecting different results is insanity”. Even he wouldn’t have imagined this being applicable to interest rates.

Maybe it’s time to think beyond monetary policy rates because the challenges of a globalised economy are more complex than the one in the 1990s waiting to be liberated.

One comment

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RBI just crashed all hopes. However the rates will come down over the nex few months given the sluggish growth and lower credit offtake.
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