The basic premise of the RBI contention of interest rates increases being one of the factors in explaining investment slowdown is as follows: estimates suggest that real effective bank lending interest rates, though positive, remain comparatively lower at present than the levels seen during the high-growth phase of 2003-08, and hence factors other than interest rates are contributing more significantly to the growth slowdown.

We don?t deny the first part of the proposition. In fact, as the accompanying graphs show, real effective lending rates are much lower currently as compared to the boom period (for example, the April 2012 real effective lending rate is 200 basis points lower than April 2007 levels). So, our disagreement lies elsewhere. As graph 1 shows (corroborated by graph 2 over a shorter period, FY06-FY10), nominal interest rates have actually not declined significantly throughout the reference period (April 2007-April 2012). For example, the nominal rate was 10.5% in April 2007, with IIP growth at 17.8%, whereas it was 9.6% in April 2012 with IIP growth at a negative 0.9%. Additionally, during the period under consideration, real effective lending rates are, in fact, higher when they should have been lower and vice versa. Moreover, it is not clear how the boom period becomes a reference for comparing real interest rates across the entire business cycle (boom and bust).

This downward rigidity in nominal interest rates is equivalent to a leaning with the wind/procyclical monetary policy. In effect, with RBI perceiving inflation to be currently accelerating, it is putting an upward pressure on interest rates by restricting the growth of M3. This, in turn, is affecting overall economic activity negatively at a time when RBI should have given it a boost. This is in contrast to standard textbook theory, whereby monetary policy is perceived to be countercyclical (if economic activity is waning, the central bank?s attempt to boost output and employment by increasing the supply of money), thereby putting a downward pressure on interest rates and stimulating growth.

RBI has also contested the point that an increase in interest cost impacts profitability margins by pointing out that non-financial firms accounting for more than 85% of business have minimal interest cost as a percentage of total sales. However, this contention fails to recognise that the cost of capital is a significant determinant of investment behaviour of such firms (substantial empirical research supports this) and an increase in interest rates may well render the future cash flow from the planned projects unviable for the firm in question.

However, the larger question is the debate on the current monetary policy stance. In economic literature, monetary policy is supposed to be countercyclical and complement macro-prudential policies that are procyclical in nature. In particular, historical experience shows that any monetary policy strategy narrowly focused on stabilising inflation, over a short horizon, may not be sufficiently forward-looking to ensure financial stability, and hence stabilise inflation over the longer term. Evidence suggest that asset prices have boomed during periods of low as well as during high inflation. Therefore, with a relatively short forecasting horizon, monetary policy may inadvertently accommodate or even contribute to the build-up of financial vulnerabilities. We, therefore, believe that the monetary policy framework must encompass a sufficiently longer-term targeting horizon and these would help policymakers to understand longer-term threats to financial stability, including the impact of interest rate settings, against short-term inflation. The result would be a more comprehensive assessment of the balance of risks facing the economy.

Additionally, RBI conjectured in the June 18 monetary policy that the rupee depreciation over the past several months has resulted in domestic producers gaining in competitiveness over foreign producers. The assumption that this will drive exports is not supported by facts. For example, India?s net exports (trade deficit adjusted for invisibles as a percentage of GDP) constitute only negative 4% of GDP, and it is inconceivable how it can compensate for the loss of domestic, especially investment, demand.

RBI?s repeated pronouncements regarding desirability of sacrificing near-term growth to contain inflation suffer from a delusion of growth abundance in India. A reality check is in order. As per the latest IMF data on real GDP growth during 2011, India?s growth rate at 7.2% was 26th in ranking, as compared to China, which was the 10th fastest growing economy. Countries like Ghana, Argentina, Turkey and even neighbouring countries like Sri Lanka grew in excess of 8% during 2011. Clearly, India has slipped in recent times in cross-country growth rankings.

In the end, we believe that the RBI action to hold interest rates may have been driven by the paramount concern from the external sector. Any cut in interest rates would reduce arbitrage opportunities opened recently by liberalising debt capital flows, putting further pressure on the rupee. However, the rupee continues to fall, reflecting a further loss of investor confidence, and hence RBI medicine is clearly not working. With the global economy continuing to be on the verge of collapse, we believe RBI may have to go for some swift and large policy action, as was the case in the post-Lehman crisis period. With LAF borrowings currently at significantly comfortable levels (R25,000 crore), a cut in the policy rate will be that much more effective through a better monetary transmission mechanism. But, most importantly, the government must initiate some policy reforms to beef up investor confidence!

Rajiv Kumar is secretary general, Ficci. Soumya Kanti Ghosh is director, economics & research, Ficci. The authors thank the Ficci economics team. Views are personal