The time has come to cut interest rates

To cut or not to cut interest rates is the dilemma facing the Reserve Bank of India as it formulates its bimonthly review of monetary policy. As usual, there are pressures from the press and the public, especially the business sector, for some relaxation in policy in the context of the trends in growth and inflation.

Adding to this clamour for liberalisation is the powerful voice of the Finance Minister, who feels it is time to cut policy rates. Inflation, whether measured at the retail or wholesale levels, has come down substantially. There is hope that the central bank’s target for January 2015 and 2016 of consumer inflation being 8 per cent and 6 per cent, respectively, may be realised.

Inflation, based on the Consumer Price Index (CPI), eased to a record low of 5.52 per cent in October 2014 as food price rises slowed sharply. The inflation rate in India averaged 9.23 per cent from 2012 until 2014, reaching an all-time high of 11.16 per cent in November 2013 and a record low of 5.52 per cent in October 2014.

The annual rate of inflation, based on monthly Wholesale Price Index (WPI), stood at 1.77 per cent (provisional) in October 2014 (over October 2013) compared with 2.38 per cent (provisional) for the previous month. The build-up of the inflation rate in the financial year so far was 2.00 per cent compared with 6.23 per cent in the corresponding period of the previous year.

The news on the growth front is also encouraging. Improved performance of the mining, manufacturing and services sectors pushed the country’s economic growth rate to a two-and-half year high of 5.7 per cent in the first quarter of 2014-15.

There is hope that the economy will grow at 5.5 per cent, if not more, this year.

The previous high GDP growth rate was 6 per cent recorded in the October-December quarter of 2011-12.

Prima facie there is a case for some relaxation in the policy, taking advantage of the trends in inflation and growth. Although the kharif foodgrains output has been affected due to inadequate rainfall, it could be made up during the rabi season due to late seasonal rains leaving moisture in the soil crucial for the next crop.

In any case, there are abundant food stocks available with government to make effective market intervention to control prices. The increased food prices seen in the recent periods was illustrative of the general ineptitude of the UPA government that characterised economic management. The decline in vegetable prices may continue with the arrival of rabi stocks.

If the coalgate issue is sorted out and coal as raw material is provided to the electricity sector, there could be a substantial fillip to manufacturing. Globally the decline in oil and commodity prices is a welcome sign.

There is a case for reduction in the cash reserve ratio (CRR) and policy rates by 25 basis points each. The trends in money supply and reserve money are subdued which have also contributed to the lowering of inflation rate. Thus, on an annual basis, as on October 31, 2014, M3 increased by 11.3 per cent, against 14.5 per cent a year back.

During the financial year 2014-15 the rise was 6.8 per cent against 8.7 earlier. As on November 14, 2014, reserve money rose by 8.1 per cent year against 9.4 per cent a year back. During the current financial year so far the growth was only 0.9 per cent against 6.8 per cent during the corresponding period of the previous year.

The slowness in these variables is attributable to the slower growth in deposits and credit. Industry seems to be resorting directly to the markets to raise resources. Commercial paper (CP) issued by companies stood at ₹2,185 billion on October 31, 2014 against ₹1,575 billion a year back.

Obviously, companies find it preferable to borrow from the market directly rather than from banks. Does the disintermediation result in a fall in deposits? One has to keep in mind that even the borrowing from the market takes place within the banking sector, there being only transfers in bank accounts. The general decline in deposits should be attributed to the subdued growth rate of the economy, especially in the manufacturing sector.

A fall in interest rates may encourage the companies to borrow more from banks. However, it should be made clear that the lower rate of interest is an incentive only from the point of view of profitability. It will not result in any reduction in the cost of production of commodities. Company finance studies show that interest costs account for only a small proportion of the total cost.

The one benefit that will flow from a reduction in the policy rate will be a fillip to the construction sector and personal loans. It is well known that from the point of view of input-output or inter-industry tables the construction sector has the greatest linkages to the other sectors of the economy with considerable spillover effects. In advocating a cut in interest rates the Finance Minister has also pointed out the benefit to the construction sector.

The writer is a Mumbai-based economic consultant