RBI's folly: Why the market will push up interest rates

By Shanmuganathan Nagasundaram

Now that the euphoria around the 50 basis points (bps) rate cut by the Reserve Bank of India (RBI) has died down, it’s probably a reasonable time to objectively evaluate its implications. Not unexpectedly, the RBI’s apparently pro-growth action received praise from all quarters - bankers, industrialists, the all-important stock markets, finance ministry officials, industry associations, etc. A nearly unanimous A+.

Or is it really?

This situation begs the question - for a move that has such widespread approval, why stop at 50 bps? Why not take the interest rates even lower than the current 8 percent? Maybe all the way down to “zero” as Helicopter Ben (US Fed chairman) has done. Wouldn’t that release the “animal spirits” and drive super-growth in the years ahead?

[caption id=“attachment_300701” align=“alignleft” width=“380” caption=“In effecting a cut at a most undesirable time, the RBI governor has ensured that the above charade is going to lose its efficacy. AFP”]  [/caption]

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Before answering these questions, it’s probably worthwhile to point out the overall context in which central bankers operate. Interest rates, after all, reflect the “price of capital”. It’s the equilibrium point at which the supply of capital (from savers, who happen to be middle-class individuals who consume less than they produce, and save the difference) meets the demand for capital (from corporates, for legitimate investment purposes, and from the government - for whatever it wants to do in the name of greater national interests). It’s no different a mechanism from the way prices of cars, tomatoes and commodities are set in the market.

So a single institution settling the price of capital should really strike as something odd about the entire process - how does one person or a group of individuals know what the correct price of capital is? Why not leave it to the markets to decide on what the interest rate should be? That, of course, is another topic and I shall reserve the same for a later date commentary.

The way the system currently works is that given the voracious appetite for capital, especially from government, the demand for capital is almost always higher than the supply. The RBI then steps in to conjure this additional capital from thin air in what is euphemistically referred to as debt monetisation.

Readers should remember that this funny capital which is perfectly fungible with real capital has no savings backing it up. This funny capital then works its way through the system resulting in a transfer of purchasing power to the early recipients (by definition, the government) from the citizens through the mechanism of increased consumer prices. The media generally refers to this as inflation, while ignoring the causative factors which is that consumer price increases are the result of the inflation of the money supply created by central banks.

So what the rate cut does is to increase the demand for capital, while at the same time lowering the supply of the same. This would directly result in increased creation of funny capital, and consequently, higher consumer prices. The difference between the funny capital that the previous RBI Governor, YV Reddy created (increased M3, a broad measure of money supply, at an annualised 20 percent during his tenure) and the current incumbent Duvvuri Subbarao (the growth in M3 has fallen to about 17 percent) is for the latter to have the misfortune of operating in an environment when the usual lag between increased money supply and consumer prices has pretty much evaporated.

So while the conditions permitted Reddy to pretend to be a hawkish central banker while cranking up the note printing presses at the same time, such fox-guarding-the-hen-house act is no longer possible (in Reddy’s defence, he probably could not see the correlation between money supply increases and higher consumer prices. So maybe he was not pretending. But I don’t know if RBI governors can be in this state of bliss).

Having pointed out that the interest rate was lower than what it ought to have been even before the rate cut, we could then answer what could be an appropriate level for interest rates. Savings, which are a pre-requisite for investments, happen in the free market when the players are compensated for the loss of purchasing power as well as for the delayed gratification of consumption. So maybe about 2 percent (a purely arbitrary call on my part) premium to the cost of living increases could be considered as normal.

In India today, this cost of living increases happens to be around 11 percent (forget CPI, WPI or core rate. Never a fan of self-appraisals, which is what the CPI/WPI statistics really are, I would always look at the difference between M3 growth rate and the GDP growth as the rate of consumer price increases). Consequently, around 13 percent would be the risk-free rate that would be desirable for the economy to sustain savings and investments.

Whether the RBI likes it or not, the market is going to force interest rates in that direction in the months and years ahead.

What then are the implications of the rate cut? Less savings leading to less investments resulting in lower GDP growth. And, of course, higher consumer prices. For a long time now, government officials have attributed the price increases we have had to the high growth India has witnessed over the last few years (the economic truism, of course, is that we have had price increases “inspite of” the growth, not “because of” the growth).

In effecting a cut at a most undesirable time, the RBI governor has ensured that the above charade is going to lose its efficacy. Given that they no longer will be able to “round up the usual suspect”, what are they going to blame future price increases on? Take your pick from greedy speculators and weather and terror premiums and supply-side constraints and infrastructure bottlenecks and lavish corporate lifestyles. One could also blame cost-push and increased inflationary expectations and surging gold prices and maybe even, future anticipated higher growth.

Never will it be the inability of the government to live within its means.

Shanmuganathan “Shan” Nagasundaram is the founding director of Benchmark Advisory Services - an economic consulting firm. He is also the India Economist for the recently launched World Money Analyst, a monthly publication of International Man. He can be contacted at shanmuganathan.sundaram@gmail.com