Interest rate hikes desirable as real interest rates too low

Interest rate hikes desirable as real interest rates too low

Rising inflation because of structural issues like rising consumption in rural areas and a demand-supply mismatch as well as cyclical factors such as a spike in commodity prices will pose the biggest risk to India’s growth trajectory in 2011, said Taimur Baig, Singapore-based economist in Deutsche Bank AG’s global markets research team, in an interview. Edited excerpts:

What is your outlook for India in 2011?

I expect high growth and high inflation. Although the expectation is that thanks to high base effect and favourable monsoon we will see inflation heading to 6% by March—that in our view would be the bottom.

As the base effect wanes and demand remains strong, inflation will be high for the rest of the year and stay at 6%-plus. It is hard to see how the supply side can keep up with the strong demand dynamic in the country. So we would continue to see inflation rising because of this demand-supply mismatch, as well as due to factors such as distributional inefficiencies and rise in administered fuel prices in response to rising global commodity prices.

So do you think all this talk of inflation dropping to 6% by March is a bit too optimistic?

I think the risk to the inflation forecast would be to the upside and I think the Reserve Bank of India (RBI) said something similar in its last policy statement (RBI’s inflation target for March is 6%).

So we are not in disagreement with the RBI, but we have been making the argument for a very long time that India is going through a series of changes, both cyclical and structural, that would keep the inflation rate high for a considerable period.

If I may draw a parallel, this is where India differs from the Chinese growth story. Over the past two decades, China has managed to grow very fast, but has maintained fairly low average inflation as well as low average inflation volatility.

India in contrast is seeing pretty high growth, but it’s accompanied by very high inflation and a pickup in inflation volatility. Just look at the last two years—it went down to zero, then it went up to 10 and now it is coming down to 6 and expected to go up again.

RBI has also said that it cannot hike rates because of the liquidity tightening. What is your view?

I think the RBI made it clear that even if ameliorative measures are taken to ease the liquidity tightness, it should not be viewed as a change in monetary stance.

Note that we started 2010 with abundant liquidity; as the year progressed a lot of money was withdrawn not from the system, but from the banks and was transferred to the government because of third-generation telecom auctions and initial public offers. It is important to recognize that the entire system is nowhere close to being illiquid. As government spending picks up in the coming month and cuts in the statutory liquidity ratio take effect, banking system liquidity tightness should ease.

The liquidity problem in my view is a short-term technical issue and monetary policy should be geared towards raising interest rates. Despite rate hikes up to 150 basis points in 2010, we still have negative real interest rates. Even looking forward, a repo rate of 6.25% and inflation unlikely to come down below 6%, we are barely at a zero interest rate level.

An economy that has a real growth rate of 8-9% should not have a zero or negative interest rate and the gulf between India’s real growth rate and the real interest rate is too wide by world standards and even by its own historical standards.

And there are real costs to very low real interest rates. You already see that in very anaemic deposit growth in banks.