Rarely in India’s recent history has so much political capital been invested on a single signal. Finance Minister Arun Jaitley has said “common sense says the interest rates should come down”. Arvind Subramanian, the chief economic adviser, has deployed a fear of ‘deflation’ to propel the case for a rate cut. Arvind Panagariya at the NITI Aayog weighed in to suggest there was “room for a cut of between 50 basis points to 1 per cent”. And then there is the chorus from the choir of corporate chieftains.
It is perhaps the nature of India’s discourse on the political economy that elevates a milestone into the destination, the process into an event and a rate cut into the instrument for paradigm change. Whether “common sense” prevails or not will be known on Tuesday when RBI holds its fourth bi-monthly monetary policy meeting. Surveys and bankers are betting on a token cut of .25 per cent, or 25 basis points, while the expectation is for a “surprise” 50 basis points cut. The realists and sceptics are betting on status quo. For Governor Raghuram Rajan, it is a no-win situation—damned if he does because it will be seen as too little and damned if he does not.
There is a reality that the Reserve Bank governor is confronted with. Global conditions are in a flux. In a month or 45 days, the US Federal Reserve is expected to raise interest rates. The possibility of flight of capital is entrenched, and as IMF chief Christine Lagarde pointed out, India is not immune to it. Dollar exodus will result in depreciation of currency and impact the debt market, corporate borrowers, India’s import bill and even exports which depend on imported inputs. The RBI must balance interests as it is obliged to secure “monetary stability” and “operate the currency and credit system of the country to its advantage”.
Sure, inflation data promotes the idea of a rate cut. There is the advantage of plunging commodity prices. But there are downsides too. As Rajan points out, inflation “measured on a year-on-year basis may be low because there was an unexpected price spurt last year—the so-called base effect”. Rajan must contend with tapering of the base effect, the impact of food price inflation, and the possibility of a spike due to poor output following poor monsoon. Add the curious divergence between WPI at minus 4.95 per cent and CPI at plus 3.66 per cent—a spread of 8-plus per cent between wholesale and retail inflation—which suggests a problem.
There is also an alternate reality India dwells in. There is the expectation for a rate cut and then there is inflation expectation. The government fixes the rates for small savings in post offices and other instruments. What are the rates? The rate for 10-year NSC is 8.8 per cent, the interest rate for Kisan Vikas Patra is 8.7 per cent, the interest rate for PPF is 8.7 per cent, and for a five-year time deposit is 8.5 per cent. This week, a 10-year NTPC bond was oversubscribed 11 times. The rate it offered: 7.36 per cent tax-free for retail investors—translated, that is 8-plus per cent at the lowest tax slab. Next month, Power Finance Corporation is issuing bonds—at similar rates.
The mandarins of the government, who have been clamouring for a cut in interest rate, have scarcely shown any inclination for cutting small savings rates (which is what was done in NDA I to bring down interest rates), obviously for political reasons. There is though no such compunction about bank rates—even though it carries a risk of flight of capital from financial savings to physical assets. There is no doubt that lower cost of capital is an enabler for spurring consumption, investment and growth. But the thesis operates in a context, the principle of economics demands necessary and sufficient conditions. While it can be argued that a rate cut is necessary, it is far from certain if a rate cut is sufficiently powerful to propel growth.
Examine the possible outcomes. What does a 25 basis points cut translate into? On a home loan, a 25 basis points cut translates into a benefit of between Rs 16 and Rs 20 per lakh of loan depending on tenure. It is debatable if 25 basis points (or even a 50 basis points cut) will trigger a rush of consumers —for homes or cars, where discounts of larger denominations are not luring buyers. Indeed, a 50 basis points cut translates a cost differential of less than a quarter of a per cent for producers (in terms of the overall costing) and is unlikely to trigger a rush for new projects.
On the face of it, the economy is growing at 7-plus per cent. Even if one were to accept all the perplexing contradictions in the data, some facts are unavoidable. Bank credit growth is in single digits, exports are negative for 10 months in a row, and capacity utilisation across sectors is struggling between 50 and 65 per cent —whether it is auto, steel, cement or electricity. While there is velocity in terms of growth, the mass of demand required to deliver momentum is missing. A rate cut would work as a placebo for sentiments, but is unlikely to be a panacea given the structural and cyclical rut the economy is trapped in.
A window of opportunity beckons the India Story. The pay hikes of the Seventh Pay Commission has the potential to translate into a stimulus for consumption. The predicted return of capital post the Fed hike could help spur investment. This demands focus on addressing supply side constraints—land, labour, availability of capital for SMEs, and regulatory barriers. It is this opportunity that the government must invest its political capital on. shankkar.aiyar@gmail.com
Shankkar Aiyar is the author of Accidental India: A History of the Nation’s Passage through Crisis and Change