RBI needs to take bold steps

June 19, 2012

(The views expressed in this column are the author’s own and do not represent those of Reuters)

Expectations of a rate cut were legitimate. But the RBI preferred to pause, not quite convinced that inflation is under control. That has been its singular target though it is dressed up to look more appealing as growth-inflation dynamics.

What is a matter of anguish is not that the RBI preferred a pause but its presumption that the relation between interest rate and investment was weak.

“Our assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small,” the RBI elaborates. “Consequently, further reduction in the policy interest rate at this juncture, rather than supporting growth, could exacerbate inflationary pressures.”

It is certainly true that the investment climate has been vitiated by corruption revelations which have delayed decision-making by the government, the euro crisis which created uncertainty and depressed foreign investment, as also the policy holiday that the government was forced to take to appease its allies in the coalition. But these do not belittle the impact of high rates that forced companies to shelve projects which had lost viability.

Interest rates are critical. In 2008, the world economy would have collapsed following the financial crisis in the U.S. The Federal Reserve, as also other central banks, took immediate steps to cut interest rates and infuse liquidity to prevent certain disaster. Had this not been done, the U.S. economy would have gone into a depression which would have been deeper than 1929.

The RBI too had followed the same strategy although inflation in 2008-09 was more than what it is today. In a matter of months, the repo rate was slashed from 9 to 4.75 per cent which boosted GDP growth from 6.8 to 8.1 percent and brought inflation down to 3.1 percent.

Interest rate counts and for companies it counts a lot more. For three reasons. First, the high rate cuts into the net profits of companies and reduces the funds available for re-investment. Second, companies are unable to raise equity because high rates knock down the stock market. Retained earnings and equity consequently fall short in providing enough backup for borrowing which is also made unattractive by the high interest rates. It is no wonder that investment dropped by 1.5 percent of GDP and industrial growth shrank to less than 1 percent.

Surely, other factors have come in the way of investment. Some were beyond the control of the government, some became politically difficult and others that delayed decision making in government. That did not mean that the RBI should have added another factor that made investment unviable.

The need today is for the RBI to take bold steps. The economy is on the wrong side of the cycle and it can be boosted only by heavy cuts in interest rates. The RBI had done that in 2008-09 and should repeat that strategy now to bring the economy back to growth without higher inflation.

No comments so far

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/