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RBI Rate Increase:EXPECT SLOWER GROWTH, by Insaf, 19 Sept, 2011 Print E-mail

Events & Issues

New Delhi, 19 September 2011

RBI Rate Increase

EXPECT SLOWER GROWTH

By Dr PK Vasudeva

(Adviser, Inst of Dev Studies)

 

The business environment continues to remain extremely challenging this financial year as it did last year. Even as there were signs of global economic recovery in 2010-11, a number of geo-political developments have raised new concerns.

 

The debt crisis in Europe, the earthquake and resultant tsunami in Japan and political turbulence in the Middle East and North America have led to considerable volatility in prices of commodities and currency exchange rates.

 

Worse, the recent developments relating to the American economy have also impacted markets. Whereby, the effects of the global financial tremors are also being felt by the Indian economy. Add to this, the rising inflation rates which is nearing double digit, remain a major concern for economists.

 

Importantly, the Reserve Bank of India (RBI) continues to increase the interest rates, which have led to the cost of borrowings going up. Not only have investment decisions been affected but also it has impacted the rate of growth in the country’s GDP. Indeed, only on Friday last 16 September the RBI yet again raised the price of money, the twelfth time in about a year.

 

In its monetary review report the RBI stated, “The inflation remains high, generalised much above the comfort zone of the RBI. In recent weeks, as a result of global risk aversion, the rupee has depreciated which may have adverse implications for inflation.” Undeniably, this is also one of the reasons why the crude prices are going up which is resulting in the hike of petrol price in India.

 

However, inflation has not come down and prices are still rising by 9-10 per cent annually. Even the UPA Government’s Chief Economic Advisor Kaushik Basu seems to think that this is the rate the country will have to live with for a long time.

 

On the other hand, the Finance Minister Pranab Mukherjee believes that inflation has peaked but it could just mean prices will not rise more than 10 per cent. Whether the rate of increase will decline is not something even he is sure of.

 

Recently, the Prime Minister Manmohan Singh and his advisers insisted that growth was possible at over eight per cent but without inflation crossing the Lakshman Rekha of 5-6 per cent for which some strong measures like tightening the belt and reducing of subsidies would have to be taken.

 

However, the RBI maintained that any growth above eight per cent was risky from the inflationary point of view. Finally, some months ago the Government came around and accepted this view and lowered its growth targets to a sub-eight level.

 

Against this background it is a moot point whether the RBI should have raised interest rates now. Clearly, the RBI Governor Subbarao had very limited options available. Thus money will now become a bit more expensive. Wherein, the middle class which desires to buy homes and small cars would have to dish out a heavy interest on the loans. Hence, the mid-income people might have to wait till the situation improves and inflationary trends ease out. Coupled with this, unless the flow of black money is stopped there is no likelihood of controlling the inflation.

 

Pertinently, as far as big corporates are concerned, the recent liberalisation in the rules governing external commercial borrowings (ECB) opens up more opportunities for them to raise cheaper funds overseas. Without a doubt, they have now been allowed to borrow up to a billion dollars in the renminbi, the Chinese currency, within the overall $30-billion annual ECB ceiling.

 

Further, a quarter of their ECB proceeds can be used to re-finance costlier rupee loans. Therefore, the latest move by the RBI to make Indian money costlier should not be a major obstacle for investment by large firms. This is the good news. The bad news is that lesser mortals will have to think twice now before borrowing. To that extent, the demand for money might abate and have some impact on inflation. But by how much and when, even the most sophisticated models cannot predict.

 

Moreover, given the strong imported component in the current inflation, it could be argued that unless the demand in the BRIC countries (Brazil, Russia, India, China and South Africa) shrink substantially to bring down global commodity prices, the tinkering by the RBI with rates might not be of much use. Undoubtedly, this is beyond the control of the RBI.

 

This apart, a related issue is the difference in interest rate between India and abroad — now about 7 per cent — which could lead to higher capital inflows. Therefore, in the absence of guaranteed returns as in the late 1980s, the current elevated exchange rate risks might act as a speed-breaker. But nonetheless, the RBI would still have to keep a vigilant eye because it is not just speculative flows, but even higher overseas borrowings by Indian firms that could make a difference to the balance of payments.

 

In the ultimate, this shows that the RBI has sent the right signal. Governor Subbarao has maintained for quite some time that the Bank does not mind sacrificing a bit of growth to bring down inflation. Given that it is the worst enemy of price rise, which needs to be controlled at all costs. In addition, the growth of money supply, non-food credit and the Gross Domestic Produce (GDP) needs to be checked to control inflation. ---- INFA

 

(Copyright, India News and Feature Alliance)

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