Of inflation and interest rates

The Headquarters of the Reserve Bank of India in Mumbai.-SHASHI ASHWAL

Unless the government penalises speculators and tightens further the regulations on futures trading, buoyancy in prices is likely to persist.

WITH inflation as measured by the wholesale price index inching towards 7 per cent and that measured by the consumer price indices ruling even higher, the government and the Reserve Bank of India have decided to sit up and take note. Exports of some essential commodities have been restrained and the prices of petrol and diesel reduced. The cash reserve ratio is to be hiked in stages to impound the equivalent of Rs.14,000 crores of loanable funds. None of these steps has as yet been effective in curbing inflation. Even if they impact prices with a lag, they are likely to be neutralised by speculation, facilitated by excess liquidity and a liberalised futures market. Unless the government penalises speculators and tightens further the regulations on futures trading, buoyancy in prices is likely to persist.

An obvious consequence of inflation that is of serious concern is its impact on the real earnings of the common man, especially since the price increase is sharper in the case of essential commodities. But a less discussed fallout could be on interest rates as banks are forced to raise deposit rates to neutralise the effects of inflation and keep depositors happy.

Since interest rates have already been rising, the latest increase could take them close to levels that prevailed during the much-maligned, pre-reform years of `financial repression'. This would in turn necessitate an increase in lending rates, which would have adverse consequences for growth.

One of the successes of financial sector reform, according to the government and RBI, is the reduction in nominal interest rates when compared with the pre-reform period. These low rates have not only shored up corporate profits but also encouraged the debt-financed spending spree, which is an important driver of India's high growth. Retail lending and housing finance have been growing at a pace that has forced RBI to warn banks repeatedly against overexposure in these markets. The danger is that a quick and sharp rise in interest rates may not just correct such overexposure but dampen debt-financed consumer spending and housing construction and spoil the party for a government that prides itself on having moved the country onto a higher growth trajectory. This effect on demand and growth would be more severe if rising rates precipitate widespread default of floating rate debt payments.

The evidence shows that even before inflation raised its head interest rates had been on the rise. Part of the reason was that banks were being forced to raise deposit rates to attract depositors and were pushed into raising lending rates to cover the higher cost of funds. Deposit rates have to be hiked because savers now earn better returns on instruments such as mutual funds and unit-linked insurance. Those better returns are drawing savings away from traditional investments such as deposits at a time when banks are finding new opportunities to lend in the housing and consumer finance market. To cater to this demand, banks were competing with one another and with other financial businesses to offer better deposit rates since they were confident of finding people willing to borrow even when lending rates were raised to cover the higher cost of funds.

This has created a situation where banks have a special interest in this year's Budget. Normally, so long as the Budget is `growth-oriented' in the sense that it is likely to keep growth going or spur it on, banks should be happy. A booming economy should spell booming business for the banks. But at the moment banks are finding it difficult to keep their traditional business going without raising interest rates to mobilise more deposits. Since this would require raising lending rates as well, it may prove contrary. Higher interest rates in the retail and housing finance markets may curb credit demand. Banks today get a significant share of their income from other areas into which they are diversifying. But lending based on deposits is what banks still know to do best.

They would, therefore, like a situation where they can continue with business as usual without raising rates. But for that the differences in rates of return in different financial markets must not widen. Unfortunately, the government has been privileging the equity market at the expense of banks. By relaxing regulations and norms that apply to both domestic and foreign investors in the stock market, it has encouraged a flow of funds into that market, which has resulted in a prolonged boom not warranted by fundamentals. With returns on stock market investments placed at close to 50 per cent, the security of bank deposits appears to be a small recompense for the much lower returns they offer.

In addition, the government has been spurring the market by encouraging new investors such as those in charge of government pension funds to move into the market and privileging financial savings in forms other than bank deposits through its tax policies. Tax benefits given on equity investments, such as the abolition of the long-term capital gains tax on investments in the stock market and the decision not to tax dividends in the hands of the recipient, have all discouraged savings in bank deposits and encouraged investments in other kinds of financial assets. This is why there are demands being made that the coming Budget must `level the playing field' for the banks. That would save them from pushing interest rates to higher levels.

This pressure on the banks notwithstanding, the recent hike in rates would not have happened if RBI were not also keen on higher rates. The central bank's call for moving up interest rates is driven by a completely different motivation: its concern with overheating in the economy, reflected in rising inflation.

Though RBI had chosen to focus more attention on growth and exchange rate management during the years of moderate inflation, in the final analysis, like all conservative central banks, it is inflation that constitutes its primary concern.

RBI has only two levers to control inflation: curbing credit expansion and raising interest rates. Curbing credit growth is a problem because RBI has recently been buying up dollars flowing into the economy in order to prevent an appreciation of the rupee. And in recent months that inflow of foreign exchange has been unrelenting. The rupees RBI outlays to buy up these dollars are contributing to an increase in liquidity and money supply.

To limit further credit creation on the basis of this increase in liquidity, it has recently chosen to raise the cash reserve ratio to be maintained by banks and expects to pre-empt around Rs.14,000 crores of loanable funds. But this only increases the desire of banks to increase their deposit intake so as to maintain credit growth, contributing further to their tendency to hike interest rates.

This has made the task of the central bank easier when it comes to the second of the levers it has at hand to curb inflation: raising interest rates. Not surprisingly what the central bank has done is to signal its desire to keep interest rates rising by raising the Repo Rate to 7.50 per cent from 7.25 per cent. This has created a rift between the central bank and the Finance Ministry. The latter, enamoured by the high growth the economy is recording, is against raising interest rates since that could slow down growth. It has, in fact, tried to pressure public sector banks not to raise interest rates on housing loans. But faced with little option in protecting their profits, banks are unwilling to oblige. Many public sector banks have indeed hiked their prime lending and housing finance rates. The Finance Ministry cannot make the banks pay the cost of its honeymoon with the stock market.

This raises the question as to which is better for the economy and the common man: higher or lower interest rates. In principle, higher interest rates benefit the rentier classes at the expense of those involved in productive activity.

Higher rates, therefore, are not good for a developing economy. In post-reform India, this feature of high interest rates is worsened by the fact that growth has come to depend heavily on debt. Higher interest rates are adverse for entrepreneurs not only because as investors they are hit by the higher cost of capital, they could also be hit by the fact that expensive credit can curtail the growth in demand for their products.

This is a fact that is forgotten when low interest rates are principally seen as reducing the return on deposits by individuals in the banking system. These individuals are also income earners who could benefit from a growing economy, unless they are retired senior citizens depending on interest rates from fixed deposits for their income. This should influence the Finance Minister not just to focus on inflation but actually to consider the case of the banks and level the playing field between the deposit market and the market for other kinds of financial assets so that they can keep deposit and lending rates down. As is the case currently, the concerns of senior citizens can be dealt with separately.

But such a move would go contrary to the Finance Ministry's recent tendency to adopt measures aimed at sustaining the irrational boom in the stock market. It would require a change in the mindset that believes that a rising Sensex is a more potent indicator of the success of reform than low interest rates. If not, the growth rates it proudly reports could be the casualty.