The latest Wholesale Price Index numbers, which peg inflation at around 10.2%, present Reserve Bank of India (RBI) governor D. Subbarao with a huge dilemma. But, like everything else in the Indian economy, the inflation dilemma, too, has multiple layers and facets.
The initial spike in inflation in the October-December quarter of 2009-10 was driven by primary goods. Over the last five to six months, though, the price pressures have shifted from agro to industrial commodities. So there is a clear indication that the economy is starting to overheat. The fact that inflation has crossed the psychological benchmark of 10% also means that there would be all-round pressure to take action to rein in inflation. The fuel price decontrol announced at the end of June, while being hailed as progressive, has definitely added to RBI’s burden.
Under such circumstances, the reaction from most central bankers would be to opt for an interest rate hike—as RBI did, mid-cycle, on 2 July. However, this is not an easy and obvious choice. RBI is caught between domestic needs, the government’s agenda and an international situation over which it has little control.
The first angle of the dilemma is global. The problems of the euro zone are squeezing global liquidity. In a bid to ease this, as well as to aid economic recovery, most central banks have kept interest rates low. The US Federal Reserve, for example, has kept its rates at a historic low of 0-0.25% since December 2008.
Given this, most good Indian companies might well be able to borrow at rates that are between 1-2 percentage points above the London interbank overnight rate, or Libor—a global benchmark. That means, if RBI raises domestic interest rates too high, more companies will be pushed to borrow overseas, leading to an upward pressure on the exchange rate (as more debt flows into India). RBI doesn’t want that either.
The second angle that complicates the situation is the mismatch between the short term and the long term. Currently, we have excess liquidity and, till recently, low interest rates at the shorter end— but harder to get and more expensive liquidity at the longer end.
That’s because both savers and borrowers are inclined to stay at the short end of the curve. Bank customers put in short-term deposits. And the massive amounts that telecom companies borrowed to pay for the 3G (third generation) fees have all been funded with short-term loans of 6-12 months’ duration. With such a massive demand for short-term borrowing, banks have been able to oblige; they had surplus funds lying with RBI. The central bank is obviously looking to change this. History has shown that excessive short-term funding invariably leads to the formation of asset bubbles.
This creates a problem as the true investment in the economy happens through longer term investments—currently the most in need are infrastructure and mortgages. That means these borrowers need low long-term rates. So the dilemma confronting RBI is how to control shorter-term liquidity and rates without an undue spike in long-term rates.
Yes, low long-term rates will also have negative consequences for pensioners who are, after all, the providers of long-term capital. But this is a structural problem in India where we are seeing a rapid rise in household savings and hence, structurally, over the next four to five years, a fall in interest rates affecting the interest earners. There are no easy answers to this.
What RBI then needs to do, over time, is find a mechanism to encourage banks to lend more in the long term and less in the short term. This could be done using differential interest rates. Currently there is hardly any difference between the interest rates offered by banks for short-term and long-term deposits. If RBI can create incentives for banks to offer higher rates for the latter, it would give banks access to more long-term capital and consequently lead to more long-term lending. But to do this, RBI may have to soften capital provisioning norms for long-term funding.
The third angle is political. Most analysts will argue that RBI should not focus so much on inflation. With good monsoon predictions, agricultural numbers are likely to be good. Prices of commodities such as metals have already started softening. Policymakers also understand that, beyond a certain degree, inflation is governed by supply-side glitches: Interest rates are unlikely to have any impact. The trouble is this argument does not contend with the “politics of inflation” and the pressure that puts on RBI to act.
So given this complexity, what are the choices? It seems clear that the best options lie in taking gradual steps both on interest rates as well as policy measures to curtail formation of asset bubbles and encourage short-term lending.
We would expect two or three more rate hikes totalling to 0.5-0.75 percentage point this fiscal year, in baby steps. It is quite likely that RBI might increase the risk weightage to certain sectors that have short-term borrowings.
But as I said earlier, none of these steps is easy; they will have to be handled with extreme care. This will require deft manoeuvrings, which RBI has managed in the past, and will continue to do so in the future, we hope.
Rashesh Shah is chairman, Edelweiss Group.
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