Tin­ker, Tai­lor, Bar­ber, RBI

The RBI’s in­ter­est-rate cut will hardly mat­ter to the macroe­co­nomic sit­u­a­tion

The Economic Times - - The Edit Page - Swami­nathan S An­kle­saria Ai­yar

Six months ago, I wrote a col­umn, ‘Why bother about small in­ter­est rate changes in In­dia?’, (goo.gl/7cFp1L, Septem­ber 16, 2015) that I could re­pro­duce and yet be spot on af­ter the RBI’s cut in in­ter­est rates last week. It will not change GDP growth, in­dus­trial pro­duc­tion or the in­fla­tion rate. It may not even change bank lend­ing rates sig­nif­i­cantly.

It proves once again how lim­ited are the in­stru­ments at the dis­posal of cen­tral bank gov­er­nors, and how me­dia hoopla keeps ex­ag­ger­at­ing the power of the mi­nor in­stru­ments.

Lost in Trans­mis­sion

The prob­lem is not lim­ited to the In­dian cen­tral bank. It re­lates to all of them. Cen­tral bankers have been striv­ing might­ily to re­vive coun­try af­ter coun­try and fail­ing for years. Mas­sive mone­tary stim­uli un­prece­dented in his­tory have left economies flac­cid, like failed Vi­a­gra.

Last week, the RBI cut its repo rate by 25 ba­sis points (0.25%), and an­nounced some mea­sures to im­prove liq­uid­ity in the mar­ket. Me­dia hoopla may have led the naïve to be­lieve that some­thing mo­men­tous was about to hap­pen. But at a Mum­bai con­fer­ence, Pro­fes­sor Avinash Per­saud of the Peter­son In­sti­tute said the cut in in­ter­est rate didn’t mat­ter a tin­ker’s damn, and I am in­clined to agree.

It will make no dif­fer­ence to the macroe­co­nomic sit­u­a­tion. At most, it may marginally ben­e­fit a few in­ter­est-sen­si­tive sec­tors like hous­ing fi­nance (by low­er­ing the equated monthly in­stal­ments).

RBI gover­nor Raghu­ram Ra­jan is strug­gling with the prob­lem that his in­ter­est-rate cuts are not trans­lat­ing into lower lend­ing mar­ket rates. He has cut the RBI’s repo rate by a to­tal of 1.5% in re­cent times. But bank lend­ing rates have gone down by just maybe 0.5% to 0.75%. Why are RBI cuts not trans­mit­ted to the whole fi­nan­cial mar­ket, as in the West?

One rea­son is the small­ness of In­dia’s cor­po­rate bond mar­ket. But a much big­ger rea­son is that the gov­ern­ment ar­bi­trar­ily fixes in­ter­est rates for small sav­ings far higher than a free mar­ket would bear. This po­lit­i­cal ploy aims to woo mid­dle-class vot­ers. But it means banks are re­luc­tant to cut de­posit rates for fear that savers will shift their bank de­posits into other small sav­ings in­stru­ments.

Asec­ond prob­lem, high­lighted the other day by fi­nance sec­re­tary Ratan Watal, is the ex­is­tence of in­ter­est-rate sub­si­dies for var­i­ous cat­e­gories of favoured bor­row­ers, from farm­ers to ex­porters. Many in­ter­est sub­si­dies are open-ended and un­capped. This dis­torts the fi­nan­cial mar­ket and trans­mis­sion of RBI in­ter­est-rate cuts.

Agri­cul­tural econ­o­mist Ashok Gu­lati has cas­ti­gated the .₹ 15,000 crore bud­geted for in­ter­est-rate sub­ven­tions to agri­cul­tural credit. The di­rect sub­ven­tion is 2%, with an ad­di­tional 3% for farm­ers who re­pay on time. In Mad­hya Pradesh, chief min­is­ter Shivraj Singh Chouhan has pro­vided ad­di­tional sub­si­dies re­duc­ing the farm bor­row­ing rate to zero.

One re­sult is that short-term farm credit has been grow­ing at a whop­ping 18% an­nu­ally, when lend­ing to other sec­tors barely reaches dou­bledigit growth. Has this boom in farm lend­ing spurred a pro­duc­tion boom? No. Pro­duc­tion is stag­nant. (Though this owes much to a drought.)

Gu­lati says gov­ern­ment bud­gets sim­ply don’t pro­vide enough to com­pen­sate banks for the in­ter­est sub­sidy they are forced to im­ple­ment, and could be an ad­di­tional rea­son for bank dis­tress and re­luc­tance to cut lend­ing rates in line with RBI cuts. More­over, the sub­si­dies are so large that it makes sense for many farm­ers to not use the money for farm­ing at all, but to re­lend it at open mar­ket rates. In ef­fect, they have be­come money­len­ders parad­ing as farm­ers.

A New Money Plant

Gu­lati says short-term agri­cul­tural credit from banks and other fi­nan­cial in­sti­tu­tions now ex­ceeds the to­tal value of all in­puts into agri­cul­ture by 10%! Be­sides, of­fi­cial data show that 44% of loans taken by farm­ers come from non-bank sources, and some of this is clearly cheap money bor­rowed by some farm­ers and re­lent to other farm­ers at com­mer­cial rates. Gu­lati fears that maybe 30-40% of sub­sidised farm loans are get­ting di­verted — an ab­so­lute scam.

Such sub­si­dies dis­tort not just the fi­nan­cial mar­ket but the whole econ­omy. This con­sti­tutes a strong case to shift from in­ter­est-rate sub­si­dies to di­rect cash trans­fers to farm­ers. Pi­lot projects are ur­gently needed. Once the gov­ern­ment sub­sidises farm­ers rather than farm loans, di­ver­sion to non-farm sec­tors will stop, farm­ers will stop turn­ing into money­len­ders, and the trans­mis­sion of in­ter­est-rate cuts will im­prove.

Trans­mis­sion is hardly the only prob­lem. In coun­tries where cen­tral bank rates are 0-2%, a change of 0.25% may have some im­pact. But in In­dia, com­pa­nies are bor­row­ing at 10-14%. For them, a change of 0.25% is ir­rel­e­vant. In­ter­est costs av­er­age only 3% of to­tal costs.

If the RBI in­ter­est-rate cuts re­duce this to 2.8% or 2.9% of to­tal costs, that will hardly mat­ter. It can­not soothe the woes of com­pa­nies com­plain­ing of in­suf­fi­cient do­mes­tic de­mand, a col­lapse in ex­ports, an overvalued ex­change rate, dump­ing by China, and oo­dles of red tape de­spite Naren­dra Modi’s at­tempts to im­prove the ease of do­ing busi­ness.

Mum­bai busi­ness­men say in­ter­est-rate cuts of at least 1-2% are needed. But that is not on Ra­jan’s agenda.

Sorry, mis­ter, Raghu­ram Ra­jan’s opened his own salon

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