Cost of a rate cut delay in India
The RBI took the first step to ease monetary policy by reducing CRR by 50 basis points on Jan. 24. However, it postponed an interest rate cut, in spite of the advice by the special committee, only to confirm its reputation of being cautious. But excessive caution can also cost the country a pretty penny.
Since then, there have been further developments. Liquidity in the system has been drying up and the RBI has been using open market operations to buy government securities in exchange for cash. That helped maintain the yield on long-term government securities within narrow limits though on short-term debt, like treasury bills, the government had to pay higher interest.
In recent weeks, inflation has climbed down from 9.1 pct in November to 6.7 percent in January. But while the RBI had been quick to raise interest rates with every point increase in inflation, it has been hesitant to cut rates in spite of easing inflation.
The obsession with high rates is causing growth to suffer. Last December, growth in industrial production was a mere 1.8 pct. That was mainly because of the 16 percent fall in capital goods production which reflects the sharp decline in national investment. In July-September 2011, for instance, national investment y-o-y was down from 30.3 percent of GDP to 28 percent. The main reason for holding back investment and income was the sharp increase in interest rates.
Interest rates rose to 8 percent in July 2011 from 5.75 percent in July 2010. Broadly, the rise of 225 basis points in interest rates caused national investment to shrink by Rs 621 billion in the July-Sept quarter of 2011 leading to a GDP loss of Rs 1.03 trillion.
The RBI has been careful to ensure that the interest rate for the government did not increase commensurately. Although the repo rate was up from 4.75 percent at the beginning of inflation to 8.5 percent now, the yield on 10-year government bonds moved in the range 8 – 8.5 percent. The RBI has been buying dollars or buying government securities to replenish liquidity. The full brunt of the rise in interest rates was borne by the private sector either by corporates on bank credit or by individuals on home or car loans.
It is critical that the RBI resume rate cuts. Every week of delay costs in terms of investment and income. The RBI need not wait for its quarterly review to engineer a change. It can do that at any time to correct financial imbalances. The immediate need is a lower rate and it has to be initiated now. Each passing week means a loss of Rs 21.8 billion in investment and Rs 73.6 billion in GDP.