Contact Your Financial Adviser Money Making MC
20
June 2017
 |
R.B.I (The Total Investment & Insurance
Solutions)
The role of interest rate in Indias growth is
grossly underplayed. The movement of interest rates has been strongly linked to
episodes of high growth and slowdowns in the last few decades.
There are two major puzzles of the Indian
economy that have been surprisingly left unquestioned and can be explained with
India's monetary policy actions.
First, contrary to popular belief, the Indian
economy did not accelerate in the decade following the economic reforms of 1991
any differently than it was doing in the previous decade. The decadal growth
rates of the 1980s and 1990s are more or less similar. The Total Investment & Insurance
Solutions
Second, the economy began to accelerate at an
unprecedented pace after 2003 without the benefit of any new phase of reforms.
There have hardly been any studies to explain the "why" behind these
two trends.
One of the first studies highlighting the
constancy of India's growth rate for the 1980s and 1990s was produced by Surjit
Bhalla, who showed that non-overlapping three year averages of any economic
indicator -- GDP growth, money supply, fiscal deficits, industrial production
-- were an unchanging constant throughout these two decades. The Total Investment & Insurance
Solutions
In fact, GDP growth from 1980-89 was 5.7
percent and between 1990-2002 was 5.2 percent. Bhalla (2010) points out that
the GDP growth did accelerate to 7.4 percent in each of the three years between
1994 and 1997 in response to economic liberalisation.
However, the Reserve Bank of India perceived
the economy to be overheating and tightened monetary policy. As inflation was
falling during this period, the real interest rate reached double digits and
growth collapsed. The fall in growth also needs to be looked in the light of
the Asian financial crisis, which Bhalla ignores, but the contribution of the
hawkish stance of the central bank cannot be side-lined.
By 1999, inflation had reached a low of 3.5
percent and the government decided to undertake interest rate reforms. In a
span of four years, bond yields fell to 5 percent from the double-digit figures
in the previous decade. Savings and investment rate which hovered around 25
percent in the decade from 1993 to 2002, increased rapidly reaching 39 and 42
percent respectively by 2007. Between 2004-07, real interest rates were at 2.1
percent compared to 5 percent in late 1990s.
Clearly, these trends played a crucial role
in ushering in the longest period of strong economic growth in Indian history
of above 9 percent per annum. The
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Thus, monetary policy actions can explain the
puzzles in the episodic growth and slowdowns of the Indian economy. This is not
to argue that interest rates are the only determining factor of economic
growth, but estimates show that a 500 basis point decline in real interest rate
can boost GDP growth by 1.5 to 3 percent. The Total Investment & Insurance Solutions
So, the pursuit of lowering inflationary
expectations with tight monetary policy should not come at the cost of economic
growth. The recently established Monetary Policy Committee (MPC) needs to keep
this in mind when deciding upon policy rates. The Total Investment & Insurance Solutions
In February, when markets expected the RBI to
continue with its dovish stance following excess liquidity with banks due to
demonetisation, the central bank changed its stance from accommodative to
neutral. The MPC cited three major risks for inflation that led it to do so: a
rise in international crude oil prices, volatility in exchange rates on global
cues which could lead to imported inflation, and the impact of the seventh pay
commission recommendations. The
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Surprisingly, none of the factors have
materialised in the months that have followed the change in MPC's stance. In
fact, all of them have moved in the opposite direction. OPEC's supply cuts have
failed to raise oil prices, rupee has grown stronger, and inflation has lowered
further.
In light of these factors, a dovish stance
from the MPC was expected. A continuity in its stance this month as well is
only hurting growth at a time when investment sentiments need to be revived.
Hopefully, since the latest estimates show that inflation is on track to meet
MPC's target of 4 percent inflation by March 2018, the economy will witness
much-needed rate cuts in the August policy announcement.
Nevertheless, considering the importance of
monetary policy in determining economic growth outlined above, the MPC needs a
defined model to pursue its goal of controlling inflation expectation without
hurting growth prospects. The
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It also needs to avoid springing repeated
surprises on the market to prevent unnecessary volatility. In February, the
abrupt shift in stance triggered a huge sell-off in the bond market that led to
a sudden surge in yield by over 50 basis points. The Total Investment & Insurance Solutions
The establishment of MPC was meant to infuse
predictability and informed decision-making within the country's monetary
policy decisions. That seems to have been missing in the last few policy
meetings of the committee. The MPC needs to realise the influence that its
decisions have on the country's growth rate and job creation prospects. The Total Investment & Insurance
Solutions
India urgently needs to regain the level of
growth it witnessed since 2003 and a lot needs to be done including an urgent
resolution of bad loans, which seems to have begun. But, avoiding an
unnecessary hawkish stance by the RBI would supplement government efforts in
reviving investor sentiments. The
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