On the extreme right side of logic

Reserve Bank of India (RBI) is all set to increase the interest rates to curtail the fiscal deficit. Despite the criticism, this decision is actually quite welcome in context of the economy. 

Headlines over the last few months made it quite evident that the Reserve Bank of India (RBI) governor D. Subbarao faced a lot of criticism and was under a lot of pressure over his decision to increase the interest rates in the recent monetary policy. A brief recall will clarify that in past, from the end of 2008 to middle of 2009, the governor slashed the interest rates to counter the global downturn. This was done precisely to induce liquidity into the market and to counter the financial crisis. This discount or tax-cut (interest rate) not just allowed increased spending but also hit the fiscal deficit, which registered negative growth.

Actually, his decision is based on solid ground. The Indian economy is now getting back on track with a projection of around 7.75% growth; as estimated by the Finance Minister Pranab Mukherjee in his budget speech. With the economic situation of the country (and across the globe) moving towards relative stability and the growth rate moving northwards; it was time for the government to roll-back the loose monetary policy laid out last year.

The growth in Index of Industrial Production or IIP improved to 16.8% by the end of year 2009, as compared to a negative figure in 2008; thus an increase in lending rates by a few basis points would not have substantial impact on credit demand. Moreover, the bond yields are also showing encouraging signs. Going by latest numbers, the yield on a 10-year government paper is at 7.8%, as of Feb ruary 2010, which is an increase by 21 basis points (bps).

But then, the steep rise in inflation, since last few months, made the myopic analyst go hullabaloo against the whole decision. For starters, there was (is?) a fear of this double digit inflation getting further enhanced, if the interest rate is increased further. A closer scrutiny of this issue makes it crystal clear that the whole issue of inflation is largely because of increase in food prices or in simple terms, is dominated by food inflation. A simple ground research and observation would be enough to understand the real reasons behind the rising food prices. The rise of food prices is primarily because of the problems in transportation of agricultural produce; namely fruits, vegetables and cereals. Due to dilapidated infrastructure and transportation problems (all thanks to bad roads and poor transport system), the food produce does not reach the market on time. Being perishable products, they find no takers later on due to the lack of adequate storage facilities. Thus, the whole food inflation regime is/was because of supply side problems from agriculture and not due to demand factors at any given time. For the month of November 2009, food inflation stood at 17%, fuel inflation was negative and manufactured product inflation was 4% only.

Furthermore, the rise in interest rates by RBI would not effect on food products, precisely for three broad reasons. Firstly, even today, the Indian consumer largely relies on non-processed food products which from nearly three-fourth of the total food volume consumed in India. Secondly, packaged food in India has a high price elasticity of demand which compels packaged food producers to keep the prices at the same level. Thirdly, the food processing sector comes under priority sector lending; which entitles food processors to borrow cheaper interest rates from public sector banks.

Moreover, rise in interest rate and CRR would not hamper the borrowings to a very large extent. As per official estimates, the Indian banking system presently is left with more than Rs.75,000 crores of excess liquidity, (after the recent rise in CRR). Thus, despite the hike in the CRR and interest rates, the banks should not face any major turbulence and would at any given point of time have adequate liquidity. Moreover, funds in forms of advance tax would come back into the system and top-up the liquidity. This will also allow surplus liquidity (that banks currently have) to flow into the market, which will serve the people. Moreover, the money obtained will reap future returns & make the financial market stronger.

If the government refrains itself from increasing the interest rates in a moment of populism, then it would be next to impossible for government to tackle fiscal problems in the near future. For starters, the FM announced his plans to bring the fiscal deficit from 6.5% of GDP to 4.8% and then further down to 4.1% in the Union Budget. In line with that noble thought, RBI should go by its own calculations and increase interest rates, despite huge outcry by myopic leaders and oppositions. It would in, short run, offend their vote banks, but then in long run the benefits would be quite evident. Sounds more rational, isn’t it?