This newspaper has been critical of RBIís policy of raising interest rates, especially the sharp hike of July 15, since inflation has been falling anyway and there is no evidence that the July 15 measures helped the rupee stabilise. If the rupee pulled back over the past few weeks, it was because the dollar weakened against most currencies. And while the biggest increase in WPI, and CPI, was due to food prices, there is little interest rate hikes can do to tackle this. Indeed, to the extent supply bottlenecks are exacerbating the crisis, lower interest rates are probably a better solution.
Which is what makes the current policy a curious one. RBI has hiked repo rates to signal to the market that it wants to curtail demand. It is true repo rates donít fully determine what happens to interest rates, but to the extent the transmission mechanism works, a hike in repo leads to other rates also risingóthe recent spurt in bank credit is not so much a result of industry demanding more funds, as it is the result of industry borrowing more from banks since commercial paper rates have shot up following RBI actions.
While RBI is signalling a hike in interest rates, the finance ministry has said it is willing to give banks more capital provided they used this to lend more in certain areas and at lower interest rates. If the finance ministry gives banks R100 of additional capital, banks can lend up to R1,000 given the current capital adequacy norms. And since banks will now have to raise less funds in the market, either through CASA or bulk deposits, their cost of funds will fall and can be passed on to consumers. Depending on how much money the finance ministry is able to put behind its intent, this means consumption demand will get a fillip. Since RBI canít do anything to curb government demand, the only GDP component that will continue to remain affected by the current high interest rates seems to be investmentóand that is the one that most needs stimulation right now.