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Why Only Interest Rates?

(From my Yahoo Piece)

The Reserve Bank of India increased interest rates by 0.50% on Tuesday, going beyond the expected 0.25% estimate. The Repo rate is now at 8%, which is the interest that banks need to pay in order to borrow from the RBI. The reverse repo rate, or what banks get for parking money with the RBI, is now 7%.

This sharp increase is on the back of persistently high inflation, which the RBI sees as a potential monster if not checked. Much has been made of the RBI statement saying "in the absence of complementary policy responses on both demand and supply sides, stronger monetary policy actions are required."

RBI has stated that the government is not taking on policy measures that will help control inflation, so it has to raise rates.

What are the policy measures that RBI complains are missing? The government can encourage investment into areas where supply is tight, like agriculture. If food prices rise, it can promote warehousing or lower taxes to increase supply. The lack of a strong real estate regulator, with no attention to land reform, ensures that land is not used productively and therefore urban prices go up, and agricultural land is underused. NREGA gives villagers 100 days of employment, which they prefer to the hard work harvesting in the fields. With lesser manual harvesters, and land too fragmented by inheritance to incentivize machine harvesting, there will be lesser sowing, as RBI has noted, despite a good monsoon. Supply shocks will therefore continue — and as for demand, the NREGA non-workers will still use the money to buy food items they didn’t help harvest.  The policy of keeping diesel prices low or kerosene prices lower creates demand excesses; left at parity with petrol, the price of diesel would have risen high enough to discourage demand earlier.

But policies, at their level, tend to only encourage supply or encourage demand; that is their political nature in a country where vote-banks are everything. It would be political suicide for the government to repeal NREGA. The government has been lax on reform and high on fighting corruption allegations.

So, says the RBI, we must take on that hard task of controlling inflation. But then, why interest rates? Higher rates are supposed to curtail demand by making money more expensive to borrow. But is hiking rates the only way?

Inflation is also a function of money-supply. RBI controls the total amount of rupees available, and inflation increases as this money increases, beyond a certain limit. For instance, last year, money supply (M3) grew over 16%, which would obviously result in some inflation — inflation was about 10%, and the difference is usually a "productivity improvement". Our productivity improvements are about 6-7%, and if we were to curtail the money supply increase to just 12% we should see lower inflation, one thinks. RBI could, for instance, sell some of the dollars it owns, and take the rupees it thus receives, out of circulation.  The process will reduce money supply and eventually, inflation. To cut money supply by about 10% all that may be required is to sell about $50 billion worth, just 1/6th of what we own. Taking currency out of circulation is the primary method adopted by central banks abroad (though most have only been doing the opposite right now); and RBI doesn’t even need to announce this in a quarterly policy; they can just do it. But they aren’t.

The RBI can increase reserve requirements — the cash reserve ratio (CRR, currently 6%) or the Capital Adequacy Ratio (CAR). These haven’t been increased at all in the last year or so as repo rates went up. This might actually be more successful in curtailing credit than interest rates.

Another way to reduce inflation is to work on foreign exchange prices. The RBI hasn’t traded on the markets for the last eight months, but it has intervened earlier. If it were to sell dollars and take the rupee up, to say Rs. 40 to a dollar, the 10% fall in the dollar will result in both the reduction of money supply (see above) and also prices of commodities falling in rupees. (Coffee is at a dollar price worldwide — a fall in the dollar means we need fewer rupees to buy the same amount of coffee, which is reverse inflation) In fact, going with what RBI says — that western economies are printing currency like crazy — making the rupee stronger might just be the only way ahead.

(This policy hurts exports, but we are so much more reliant on imports it shouldn’t matter)

Finally, the RBI needs to recognize that as long as people can borrow from abroad and deploy the money in India, our interest rates don’t matter. IBM might employ thousands of people in India, but it can borrow in the US and pay people higher salaries here. Changing interest rates here does nothing to deter the IBMs of the world; now a number of Indian companies like Reliance or L&T borrow abroad because it’s cheaper. One way to resolve this would be to restrict foreign fund flows, but that is such twentieth-century-thinking. Another option might be to make the rupee fully convertible. Then, the rupee will become stronger when companies like IBM borrow abroad and deploy in India, making such a fund arbitrage useless.

(Even so, the inward flow of foreign capital isn’t dramatically high — FDI has dropped in the last few months, though FII flows have restarted)

While all the above choices have consequences to the economy, it’s strange that they haven’t been addressed in a policy statement. Even if used partially, they will address inflation in a more wholesome way. Blaming the government for lack of policy measures is appreciated — we do need policy measures as well. But it’s ironical that despite having other levers to push, the RBI continues to use just the repo rate as a lever to control persistently high inflation.

Also Read: RBI On Forex Rates and CRR Hikes.

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