There are many who believe we have killed private investment by keeping rates too high: Raghuram Rajan

Mumbai, June 22 (KNN) Talking about the Fiscal Dominance, Dr Raghuram Rajan, the RBI Governor, said  one reason the RBI was historically reluctant to lock itself into an inflation-focused framework is because it feared government over-spending would make its task impossible.

The possibility of fiscal dominance, however, only means that given the inflation objective set by the government, both the government and the RBI have a role to play. If the government overspends, the central bank has to compensate with tighter policy to achieve the inflation objective, Rajan said.

Rajan said this while addressing at Tata Institute of Fundamental Research here on June 20. He was deliberating on ‘The fight against inflation: a measure of our institutional development’.

So long as this is commonly understood, an inflation-focused framework means better coordination between the government and the central bank as they go towards the common goal of macro stability; he said adding that, “I certainly believe that the responsible recent budget did create room for the RBI to ease in April.”

On arguments against what the RBI is doing, Rajan said, “There are many who believe we are totally misguided in our actions. Let me focus on four criticisms. First, we focus on the wrong index of inflation. Second, we have killed private investment by keeping rates too high. Somewhat contradictorily, we are also hurting the pensioner by cutting rates too sharply. Third, monetary policy has no effects on inflation when the economy is supply constrained, so we should abandon our attempt to control it. Fourth, the central bank has little control over inflation when government spending dominates (what in the jargon is called “fiscal dominance”).

On the Effective Real Interest Rate, Investments, and Savings, the apex bank chief said, “Of course, one reason critics may advocate a focus on WPI is because it is low today, and thus would mean low policy rates. This is short-sighted reasoning for when commodity prices and global inflation picks up, WPI could well exceed CPI.”

There is, however, a more subtle argument; the real interest rate is the difference between the interest rate a borrower pays and inflation – it is the true cost of borrowing in terms of goods like widgets or dosas. If policy interest rates are set to control CPI, they may be too high for manufacturers who see their product prices appreciating only at the WPI rate. I am sympathetic to the argument, but I also think the concern is overblown.

Even if manufacturers do not have much pricing power because of global competition, their commodity suppliers have even less. So a metal producer benefits from the fall in coal and ore prices, even though they may not get as high a realization on metal sales as in the past. The true measure of inflation for them is the inflation in their profits, which is likely significantly greater than suggested by WPI, he said.

A second error that is made is to attribute all components of the interest rate paid by the borrower to monetary policy. For heavily indebted borrowers, however, a large component of the interest rate they pay is the credit risk premium banks charge for the risk they may not get repaid. This credit risk premium is largely independent of where the RBI sets its policy rate.

So when someone berates us because heavily indebted industrialists borrow at 14% interest with WPI at 0.5%, they make two important errors in saying the real interest rate is 13.5%. First, 7.5% is the credit spread, and would not be significantly lower if we cut the policy rate (at 6.5% today) by another 100 basis points.

Second, the inflation that matters to the industrialist is not the 0.5% at which their output prices are inflating, but the 4% at which their profits are inflating (because costs are falling at 5% annually). The real risk free interest rate they experience is 2.5%, a little higher than elsewhere in the world, but not the most significant factor standing in the way of investment, he said.

Far more useful in lowering borrowing rates is to improve lending institutions and borrower behavior to bring down the credit risk premium, than to try and push the RBI to lower rates unduly, he added.

The policy rate in effect plays a balancing act. As important as real borrowing rates for the manufacturer are real deposit rates for the saver. In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits. This meant that India needed to borrow from abroad to fund investment, which led to a growing unsustainable current account deficit, said Rajan.

In recent years, our fight against inflation also meant the policy rate came down only when we thought depositors could expect a reasonable positive real return on their financial savings. This has helped increase household financial savings relative to their savings in real assets, and helped bring down the current account deficit.

At the same time, I do get a lot of heart-rending letters from pensioners complaining about the cut in deposit rates. The truth is they are better off now than in the past, as I tried to explain in a previous lecture, but I can understand why they are upset when they see their interest income diminishing, Rajan added.

The bottom line is that in controlling inflation, monetary policy makers effectively end up balancing the interests of both investors and savers over the business cycle. At one of my talks, an industrialist clamored for a 4% rate on his borrowing. When I asked him if he would deposit at that rate in a safe bank, leave alone invest in one of his risky friends, he said “No!” Nevertheless, he insisted on our cutting rates significantly. Unfortunately, policy makers do not have the luxury of inconsistency, said RBI chief. (KNN Bureau)