Mumbai: One oft-cited risk to high growth for the Indian economy lies in inflation and, by extension, high interest rates. The argument is that low rates of interest have helped sectors such as automobiles, real estate and consumer durables and raising them will slow growth.
Graphic: Yogesh Kumar / Mint
There are several problems with this argument.
The first is that slowing growth is precisely what the central bank wants when it raises interest rates, so that the economy doesn’t overheat and inflation doesn’t become entrenched. In fact, raising rates at the right time ensures that growth is sustainable.
The second is that interest rates are still rather low, so it’s not as if the Reserve Bank of India (RBI) will choke growth by raising rates a bit. In fact, most economists seem to believe the central bank was behind the curve, which accounted for RBI raising its policy rates last Friday.
For instance, the International Monetary Fund recently pointed out that the policy rate is currently around 200 basis points below the neutral rate. One basis point is one-hundredth of a percentage point.
The third point comes from the markets. The interest rate-sensitive auto index on the Bombay Stock Exchange has actually beaten its benchmark Sensex index in the last month, despite the rise in excise duties in the Union Budget. The market seems to think that growth will continue in spite of higher automobile prices, fuel and interest costs. They have a strong precedent—during the last cycle, though RBI started raising interest rates in October 2004, the boom in the economy and the markets continued till 2007.
And finally, we’re still in an early stage of the recovery cycle and it’s too early to start worrying about growth.
But that’s where the risks come in.
If we compare the current recovery with the previous one, we can say that 2010 is in many respects similar to 2004. The stock market had run up sharply in 2003, and early 2004 saw the same concerns about tighter monetary policy that we’re seeing today.
But here’s the catch: The yield on the 10-year government bond in March 2004 was 5.2%. Today, the 10-year yield is near 8%. In 2004-05, interest rates on bank deposits of between one- and three-year maturity were 5.25-5.5%—today, for State Bank of India, deposit rates for one-three- year deposits are between 6% and 6.5%.
Today, banks’ credit-deposit ratio is near 71%. In February 2004, it was 55%, implying that banks had leeway to lend much more. Money supply growth is currently around 16.4%; in February 2004 it was 14.5%, which means RBI will have to tighten more since inflation, too, is higher.
And finally, the fiscal deficit for 2010-11 has been pegged at 5.5% of the gross domestic product, while in 2004-05 it was 3.99%, which means much higher government borrowing and upward pressure on interest rates.
In short, the level of interest rates is high for the current stage of the cycle, although policy rates are lower. That raises the risk that the current recovery may be shorter than the last one.
This is the second in a five-part series on the macro-risks India faces. Part 1 looked at inflation. Part 3 will look at the monsoon. To see this and the series so far, go to www.livemint.com/macro-risksindia