There is mounting pressure on the Reserve Bank of India (RBI) to cut interest rates and pump more credit into the economy. Governor Y.V. Reddy would do well to resist these pressures from industry groups and the government.
No doubt, there are some signs of an industrial slowdown, though a very modest one. Buyers of cars, two-wheelers and some consumer durables have clearly decided to postpone purchases as the cost of borrowing has increased in recent quarters. There is some anecdotal evidence of an inventory pile-up. The drop in freight volumes is perhaps another indication of a slowdown. But buoyant collections of corporate income- tax and taxes on goods and services show no signs of tapering off as yet.
Meanwhile, the rising rupee will hurt the profits of many exporters. And while the economy is currently more dependent on investment rather than consumption for its growth, the Confederation of Indian Industry has stated that high interest rates were affecting investments. That may be a bigger long-term worry, as new investments in production capacity and infrastructure are needed to sustain a fast growing economy.
These are genuine concerns, but the votaries of lower interest rates seem to forget the other variables in a bubbly policy stew. Headline inflation is modest, but consumer prices are growing at a far faster pace than the raw numbers show, and the spurt in global oil prices will eventually have to be passed on to users. Asset prices—especially shares in the past few weeks—have rolled into bubble territory.
Another injection of liquidity at this juncture would increase pressures on consumer prices and asset prices, something RBI surely knows. Reddy will eventually have to take a call on how to balance the need to keep growth on track with the need to keep inflation in check. It’s always a bit of a high-wire act. A lot depends on a question that gets little attention in India: What rate of economic growth can India sustain in the coming years?
While we have moved beyond the 6% long-term rate of the 1990s, many economists are worried that the current growth at around 9.5% is a bit too fast to sustain, given current rates of savings, investments and productivity. In a recent working paper, International Monetary Fund economist Hiroko Oura says India can sustain a growth rate between 7.4% and 8.1%.
Actually, a modest slowdown is no cause for worry. It’ll give Indian business a well-deserved opportunity to take a closer look at its ambitious growth plans and ensure it doesn’t make the same mistakes it committed in the similarly effervescent mid-1990s. The most effective long-term strategy to sustain low interest rates is to keep inflation expectations under control and to increase the savings rate. In a meeting with bankers and industry representatives on 5 October, finance minister P. Chidambaram reportedly asked banks to lower interest rates, which would mean that depositors bear the cost of lower rates for industry. Deposit rates are already just a few notches above the consumer inflation rate. A further drop in deposit rates will hurt ordinary savers, and encourage them to shift even more money into an overheated stock market. China is a good example of how unthinking financial repression can ignite asset prices.
We have a suggestion for the finance minister. Instead of leaning on banks and their depositors, he would do well to set his own house in order. The bipartisan deal to bring down the fiscal deficit to 3% of GDP by 2009 was struck at a time when growth in both the economy and tax collections was sluggish. India could do well with far deeper cuts in the fiscal deficit in these high-growth times. The money thus released could be used to sustain investment—both public and private.
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