The central government announced further increase in import duty on gold, relaxation in FDI sectoral caps and procedures, and tried to talk up markets through the cerebral and articulate finance minister P Chidambaram. RBI has become overactive and has announced a flurry of initiatives which include cutting back on financing gold purchases, easing rules for accessing overseas loans, facilitating non-banking finance companies to raise funds overseas, tightening rules for FIIs to utilise client assets to buy dollars and asking exporters to bring back foreign exchange more quickly. What smacks of desperation is its attempt to prop up the rupee by draining liquidity from the banking system, reducing access to liquidity from RBI for banks and dramatically pushing up short-term interest rates to make it expensive for importers, exporters and currency traders to hold dollars speculatively.
But keeping interest rates high and jacking them up further hurts the entire economy, not just the currency speculators, and worsens the sentiment for the rupee. Higher interest rates negatively affect investment, decreases demand for capital goods, slows down demand for interest-sensitive products such as automobiles and housing, and reduces economic growth. Due to the perceived panic, the expectations of the value of the rupee have worsened.
The rupee was supported all these years by FII and FDI inflows, most of which went into equity investments. This investment came in because investors felt confident about the prospect of continuing high growth in India. In the recent fall in the rupee, it was disinvestment by FIIs from debt instruments to the extent of about $8 billion that was a major contributor, not disinvestment from equities which is less than $2 billion. With Indias credit rating, at just about investment grade, fragile in the context of the huge trade and current account deficits, will high interest rates attract foreign investors
There may be marginal improvement in the value of the rupee with the interest rate increase, but to sustain it, there is a need to bring back the feel-good factor. We need to bring back investor confidence that the Indian economy will go back to the growth rates it enjoyed in the recent past. Investor confidence is the key to attracting capital flows into the country from the trillions of dollars sloshing around in the world. It is capital inflows that can be of immediate help in controlling the slide of the rupee, given our persistent and large current account deficit.
We do not have the luxury of time to wait for the trade and current accounts to become positive even if, at R60 to the dollar, we have a better competitive position and serendipitously succeed in countering inflation with productivity gains.
One tried and proven way to attract capital flows is through attractive foreign currency non-resident deposit schemes (FCNR). Our banks already have the network to tap these NRIs, and concessions from RBI for banks raising such deposits (such as by way of a softer SLR/CRR incidence on such liabilities) may give them the incentive to do so.
Even FCNR inflows depend on maintaining the confidence among the NRIs that we will not go the Cyprus way or have a repeat of the 1991-type scenario. With elections to be held within a year, worrying fiscal and current account deficits and a government ready to adopt populist programmes, such confidence cannot be taken for granted.
A key initiative to bring about a feel-better sentimentfeel-good sentiment will take much longer to arriveis for RBI to slash interest rates aggressively and announce a programme of progressive reduction in the rates. The economic sentiment will improve overnight even though interest rates will take time to filter down to borrowers.
A new Governor at the central bank will take charge in October. He or she will have the freedom to reverse the interest rate stance currently taken by RBI. Under Section 7 of the Reserve Bank of India Act, 1934, the central government is empowered to give such directions to the bank as it may, after consultation with the Governor of the bank, consider necessary in the public interest. The central government must ensure an aggressive reduction in interest rates. There are numerous reasons to support such change of stance:
l Global outlook for inflation-control is better with commodities super-cycles having ended; domestic expectations of inflation are also subdued.
l High rates have not had the desired impact on consumer price index.
l Inflation in food and fuels is a supply-side issue; diesel price hikes will lead to inexorable increase in headline inflation as suppressed inflation is allowed to be manifest, whatever the level of interest rates.
l Currency depreciation feeds into inflation and fiscal deficit; interest rate reduction will boost FII investor sentiment, and attract inflows for equity investment on the prospect of return to growth, which will address inflation through currency appreciation.
l Interest rate reduction will help in boosting aggregate demand for interest-sensitive productsautos/housing/consumer durablesas well as investment demand. There is a great danger of structural damage through high interest rates: for example crippling power shortages after 2015 are expected if investment in the power sector is delayed.
l The economy has slowed down, and is slowing down further. Even mass consumer products are seeing sluggish demand and companies have resorted to discounting biscuits, detergents, milk products and the like.
Simultaneously or earlier, the central government must take complementary action to accelerate growth. To reduce imports, it should increase import duties immediately on consumer durables such as microelectronic products and white goods (which used up about $95 billion of foreign exchange last year, and are expected to further use $400 billion a year in 2020), and encourage value addition and job creation in India. In difficult times there is no reason to mollycoddle consumers of such products. It should open up liberally the defence sector to foreign investors with estimated capital expenditure in foreign currency of R7,50,000 crore over the next 10 years, a lot of jobs can be created in India over time by manufacturing in India with foreign ownership rather than importing the end products. Active supply-side management and increasing domestic production, especially of import-dependent edible oils, with close monitoring and improvement of the public distribution system can help address food inflation for the weaker sections of society.
RBI has justified high interest rates as a tool to fight inflation and now it has increased them to keep the rupee within an unstated target of R60, and fight speculators who it sees as the culprits in the recent rapid fall of the rupee. The real culprit is the negative sentiment about Indias economic growth prospects. Changing that sentiment and attracting foreign investors requires RBI to take steps to improve the growth outlook for the economy, a key element of which is to abandon its current policy of high interest rates.
The author was the founder managing director of CRISIL and runs IndAsia, a corporate finance advisory company