The rise in interest rates was preordained. With 8 per cent growth visible and talks of double digit growth beginning, India has much to celebrate. But with this growth has come a burden — inflation, led initially by food prices that touched almost 20 per cent and now by manufacturing inflation that could take the inflation rate up to 10 per cent this week.
Taking the rising inflationary expectations into account, Reserve Bank of India on Friday raised its policy rates by 25 basis points (100 basis points make 1 percentage point).
“These measures should anchor inflationary expectations and contain inflation going forward,” an RBI statement said. “As liquidity in the banking system will remain adequate, credit expansion for sustaining the recovery will not be affected.” I believe this is RBI Governor D. Subbarao’s first step. A little before its April policy, RBI will once again raise policy rates — repo and reverse repo (rates at which it lends to commercial banks and borrows from them, respectively) — by another 25 basis points.
Until then, commercial banks will not increase rate of their home and auto loans. That’s not because overnight banks have become symbols of nobility and fairness. In fact, they are under the regulator’s watch as well as the public lens, particularly on how they increase interest rates now. In the past two years, when RBI had cut its policy rates by 400 basis points to revive the economy that had fallen off the cliff on September 15 following the Lehman Brothers’ bankruptcy, banks were loath to reduce the rates for their existing customers, saying their cost of funds were locked up at high interest rates.
This created a breach of trust in the system that exists even today, though on the fringes. Now, when their cost of funds is low, there is no need to raises rates immediately, though I’m sure banks will come up with a hike, sooner rather than later, with a new justification (though I’m afraid, any rationalisation will be suspect). But it’s not merely a trust-building exercise that will prevent them from raising rates.
Despite media questions and headline-seeking provocations, not a single bank has said it would raise rates immediately. Now go back three years ago, when RBI under Y.V. Reddy was doing the same thing — the leading bank then would raise its rates the same evening; others would follow the next day. But it’s early days — and the rise in policy rates is only marginal.
Outside the financial sector, the real economy is growing, and fast, leading to stabilisation and increase in property prices. This will prevent households from terminating loans, as they are in the US, and prevent a banking collapse. The other reason why homeowners will not default is the huge unaccounted-for portion in real estate deals.
Take a walk on the economic landscape across the world and you’ll see just how marvellous this recovery looks against the hazy revival across the developed world — from the US and EU to Japan and Australia. India’s performance shows a resilience of both its financial and real economy as well as its political system. Against India’s GDP growth of 8 per cent, the advanced economies are expected to grow by 2.1 per cent (US by 2.1 per cent, EU by 1.0 per cent, Japan by 1.7 per cent).
Only China, at 10 per cent, will grow faster.
On the monetary policy side, RBI’s rate hike is a signal to watchout for and prevent the rise in inflationary pressures in the economy.
This will act along with the government’s fiscal programme in which it will borrow at the rate of Rs 14,000 crore per week, sucking out liquidity from the system. While this will bring inflation under control, the danger is that it could hold back growth by 50-100 basis points.
The question we need to be prepared for is: how slow a growth are we willing to accept to control prices in a country where a large part of its population lives below the poverty line? There are no answers yet.
But for now, I feel RBI’s steps are in the right direction.