Unintended consequence

High interest rates could accelerate the flow of foreign funds from low-yielding developed nations

By Mohan Sule
The market expressed its disapproval of the Reserve Bank of India’s steadfast refusal late last month to lower interest rates. The annoyance was understandable. Besides keeping the bank rate steady, the central bank increased the capital for banks’ restructured standard assets and downward revised the GDP growth forecast for the current fiscal for the second time. Perhaps the apparent contradiction in these positions has escaped the central bank. Low interest rates fuel growth and so also restructuring of loss-making companies, whose numbers increase during a downturn. How can the economy grow if obstacles are raised in the path of these contributors? From the policy composition, it is apparent that Mint Road believes that the major trigger has to come from the Central government and it can at best play a supporting rather than a leading role in scripting the growth story. The finance minister has to share the blame for the RBI’s obsession with inflation, particularly so with polls looming around the corner. His intention to nearly halve the fiscal deficit from the current level in another four years is fine as along the details of the roadmap are spelt out. Not a single rupee was collected from PSU divestment in the last seven months. Yet the market is supposed to trust the government in meeting the Rs 30000-crore target in the remaining period. The other three options — of trimming subsidies further, hiking taxes, and cutting spending — do not look feasible at this juncture. The recent increase in prices of fuels resulted in the walkout of UPA-II ally TMC and renewed attacks from opposition and civil society on the issue of corruption. There is the danger of the economy slipping into recession if indirect taxes are bumped up amid a slowdown. Instead of going down, spending tends to increase on the eve of election.

The inescapable conclusion is that the government is hoping for a gush of foreign funds into retail and aviation and inflows from auction of the second-generation spectrum to balance its spending spree. Why would foreign direct investors want to invest in a country that risks being slapped with a junk credit rating if it does not speedily reform seems to be beyond the comprehension of the policy makers. Against this backdrop, the RBI’s caution looks prudent. The stubborn stand, however, could backfire and create more harm than good. If inflation is the central bank’s core concern, the higher cost of money compared with other major economies, which are holding down interest rates to spur growth, could act as a magnet for hot money searching for better yields and release more liquidity. The silver lining is that high interest rates could achieve what the government has not been able to so far: foreign funds could revitalize the stock markets, boost business confidence to take up stalled expansion, and breathe life into failing companies. This means the Indian economy will no longer act in tandem with the global economy. The decoupling that did not happen post 2008 credit crisis in spite of the domestic orientation of the economy could be in the making now as a consequence of India’s reluctance to fully integrate with the rest of the globe by softening its lending rates.

There are two reasons for this unintended series of developments. First, India imported inflation along with foreign capital during the 2003-07 bull-run, which raised the affluence level. The wholesale price index more than doubled in September 2008 from five years ago. The heating of the economy was largely contributed by the surging prices of commodities. However, inflation in India did not cool down even though the collapse of Lehman Brothers halved it for OECD countries by September 2012. As a result, the gap between the middle class and the poor in India widened, spurring the launch of many welfare programs and preventing policy makers from correcting the fiscal imbalance by reducing subsidies. Together, these developments contributed to more than doubling the fiscal deficit in the four years to FY 2012. The consequence of higher interest rates and increased dollar inflows will strengthen the rupee, making imports and the cost of borrowing for Indian companies cheaper but also boost asset prices, and, in the process, squeeze the government to act. Cutting subsidies is going to fuel inflation in the short term before the impact of narrowing fiscal deficit allows the central bank to reduce interest rates. How long this period will be will depend on to what extent the government goes in slashing expenditure. Chances of the US economic recovery gaining momentum are bright after the presidential elections, providing a fillip to exports and helping in easing the pain of transition to a cleaner balance sheet. So the market should look at the current developments as half glass full.