Duvvuri Subbarao, the current governor of the Reserve Bank of India (RBI), must be a troubled man these days — professionally that is. The gross domestic product (GDP) growth has fallen to 5.3 percent for the period of January to March 2012. And now he is expected to come to the rescue of the Indian economy by cutting interest rates, so that people and businesses can easily borrow more, and we all can live happily ever after
Cows would fly, if only it was as simple as that!
The mid-quarter review of the monetary policy is scheduled for 18 June 2012. On that day, Subbarao is expected to cut the repo rate by at least 50 basis points (one basis point is one hundredth of a percentage). The repo rate is the rate at which banks borrow from the RBI. It is a short-term interest rate and by cutting it the RBI tries to manage the other interest rates in the economy, including long-term interest rates like the rate at which banks and financial institutions lend to the government, the rates offered by banks on their fixed deposits, and the rates charged by banks on long-term loans like home loans, and loans to businesses.
But the fact of the matter is the RBI really has no control on these interest rates in the current state of the economy. To understand why, let us deviate a little.
Greenspan and Clinton
Alan Greenspan and Bill Clinton came from opposite ends of the political spectrum. Greenspan had been a lifelong Republican whereas Clinton was a Democrat. Unlike India, where there are a large number of political parties, America has basically two parties, the Republican Party and the Democratic Party. Greenspan was the Chairman of the Federal Reserve of the United States, the American central bank, from 1987 to 2006.
But despite coming from opposite ends of the political spectrum they got along fabulously well. In fact, when Clinton became the President of America in early 1993, Greenspan approached him with what Americans call a “proposition”.
Greenspan told Clinton that since 1980 the rate of inflation had fallen from a high of around 15 percent to the current 4 percent. But during the same period the interest rate on home loans had fallen only by 400 basis points from 13 percent to 9 percent. Despite the fact that the Federal Funds Rate (the American equivalent of the Indian repo rate) stood at a low 3 percent.
Why was the difference between the Federal Funds rate, which was a short term interest rate, and the home loan interest rate, which was a long term interest rate, so huge?
High fiscal deficit
The difference in interest rates was primarily because of the high fiscal deficit that the US government was running. Fiscal deficit is the difference between what the government earns and what it spends in a particular year.
When Clinton took over as President on 20 January 1993, the American government had just run a record fiscal deficit amounting to $290.3 billion, or 4.7 percent of the GDP for 1992. And this had led to high long-term interest rates even though the Federal Reserve had set the short term Federal Funds rate at 3 percent.
The government was borrowing long term to fund its fiscal deficit. And since its borrowing needs were high because of the large fiscal deficit it needed to offer a higher rate of interest to attract lenders. When the government borrowed more it crowded out private borrowing, meaning, there was lesser pool of “savings” for the private borrowers to borrow from.
Hence, banks and other financial institutions which needed to borrow in order to give out home loans had to offer an even higher rate of interest than the government to attract lenders. Even otherwise, the private sector has to offer a higher rate of interest than the government, because lending to government is deemed to be the safest form of lending. Due to these reasons the difference in short-term interest rates and long-term interest rates in the US was high. So the repo rate was at 3 percent and the home loan rate was at 9 percent.
Greenspan was rightly of the opinion that a high fiscal deficit was holding economic growth back. This was the argument he made to President Clinton when he first met him. As Greenspan writes in his autobiography The Age of Turbulence – Adventures in a New World: “Long-term interest rates were still stubbornly high. They were acting as a brake on economic activity by driving up costs of home mortgages (the American term for home loans) and bond issuance.”
Other than the government, which issues bonds to finance its fiscal deficit, companies also issue bonds to raise debt to meet the needs of their business. If interest rates are high companies normally tend to put expansion plans on hold because high interest rates may not make the plan financially viable.
Greenspan’s proposition to Clinton was that if Wall Street got enough of a hint that the government was serious about bringing down the fiscal deficit, long term interest rates would start to fall . This would be good for the overall economy because at lower interest rates people would borrow more to buy houses and as well as everything else that needs to be bought to make a house a “home”.
As Greenspan writes, “Improve investors’ expectations, I told Clinton, and long-term rates could fall, galvanising the demand for new homes and the appliances, furnishings, and the gamut of consumer items associated with home ownership. Stock values too, would rise, as bonds became less attractive and investors shifted into equities.”
The US Congressional and Budget Office (CBO), a US government agency which provides economic data to the US Congress (the American parliament) to help better decision-making, upped its projection of the fiscal deficit at that point of time. It said that the fiscal deficit is likely to reach $360 billion a year by 1997. This data point put out by the US CBO helped buttress Greenspan’s point further and Clinton decided to do something about the fiscal deficit.
The Clinton plan
Clinton put out a plan which would cut the deficit by $500 billion over a period of four years through a combination of higher tax rates as well as lower spending by the government. The fiscal deficit of the United States, which had been growing steadily for years, started to fall from 1993. In 1993, it was down by 12 percent to $255 billion. By 1997, the fiscal deficit was down to $21 billion. In Clinton’s second term as President, the deficit turned into a surplus, something that had not happened since 1971. Between 1998 and 2001, the US government earned a surplus of $559.4 billion.
A lower fiscal deficit led to lower long-term interest rates and good economic growth. The United States grew at an average rate of 3.9 percent between 1993 and 2000. In the eight years prior to that the country had grown at an average rate of 2.9 percent per year. So the US grew at a much faster rate on a higher base because the fiscal deficit was turned into a fiscal surplus.
This was also the period of the dotcom bubble but the fiscal surplus was clearly not the reason for it.
The moral of the story
As we clearly see from the above example, at times there is not much that a central bank can do on interest rate front, especially when the government is running a high fiscal deficit. As I have often said over the past one month, the fiscal deficit of the government of India has increased by 312 percent between 2007 and 2012. During the same period its income has increased by only 36 percent. The fiscal deficit target for the current financial year is at Rs Rs 5,13,590 crore, a little lower from the last year’s target. But as we have seen in the past this government has a tendency to miss its fiscal deficit targets regularly. So the government will have to borrow to finance its fiscal deficit and that means an environment in which long term interest rates will remain high.
In fact, some banks have quietly raised the interest rates they charge to their existing home loan borrowers, after the Subbarao-led RBI last cut the repo rate by 50 basis points on 17 April 2012.
The interest being charged to some of the existing home loan borrowers has even crossed 14.5 percent, a difference of more than 6 percent between a long-term interest rate and the repo rate, as was the case in America.
India has another problem which America did not in the early 1990s, high inflation. The consumer price inflation was at 10.36 percent for the month of April 2012. Urban inflation was at 11.1 percent whereas rural inflation was just below 10 percent at 9.86 percent. If Subbarao goes about cutting the repo rate in a rapid manner, he runs the danger of inciting further inflation.
So the only way out of this mess is to cut subsidies. Cut fuel subsidies. Cut fertiliser subsidies. This, of course, would mean higher prices in the short term, particularly if diesel prices are raised. An increase in the price of diesel will immediately lead to higher inflation, given that diesel is the major transport fuel, and any increase in its price is passed onto the consumers. The government thus has to make a choice whether it wants high interest rates for the long term or high inflation for the short term. It need not be said it will be a politically difficult decision to make.
Over the longer term it also needs to figure out how to bring more Indians under the tax ambit and lower the portion of the “black” economy in the overall economy. (You can read this in detail here: It’s not Greece: Cong policies responsible for rupee crash).And there is nothing that RBI can do on any of these fronts.
The predicament of the RBI was best explained in a recent column titled Seeking Divine Intervention, written by Rajeev Malik, an economist at CLSA. He said: “There are three institutions that keep India running: the Supreme Court, the Election Commission and the Reserve Bank of India (RBI). To be sure, most of the economic mess in India has the government behind it. And often the RBI is called in as a vacuum cleaner. But even the world’s best vacuum cleaner cannot be successfully used to clean up a garbage dump.”
Vivek Kaul is a writer and can be reached at email@example.com