The token measures taken by RBI in its monetary policy statement acknowledged the concerns of the economists at investment banking firms and yet left the economy free of any threat from high interest rates. Concerns regarding inflation have been greeted with erudite discussion and token action. If the intention was essentially to not disturb the growth momentum by high interest rates, then the objective has been met with ?lan.
If the choice was between high inflation and high interest rates, RBI has effectively chosen high inflation for now. This is because the token measures to raise interest rates or to absorb liquidity are unlikely to raise the interest rates in the economy. Many heads of banks have already stated this in response to the policy statement. If excess liquidity is leading to excessive demand, which, in turn, is leading to high inflation, then this will continue to be so, for now. The expectation is that increased supplies from agriculture and manufacturing will soon match the excess demand and inflation will come down to more acceptable levels.
RBI predicts that inflation in the WPI will be down to 5.5% by March 2011. We believe that inflation in the WPI will be lower at 3.8% in the quarter-ended March 2011. RBI has predicted a real GDP growth of 8% in 2010-11. We believe that the economy will grow at a faster 9.2%. RBI?s benign intervention ensures that growth will be sustained.
During 2010-11, investment demand is likely to continue to remain high. The IIP for capital goods has been showing big increases in recent months. CMIE?s CapEx database has also been showing a relentless growth in the creation of additional productive capacities across all major segments. Projects worth Rs 1.1 lakh crore were commissioned during the quarter-ended March 2010. Fiscal 2009-10 saw projects worth Rs 4 lakh crore being commissioned. And, projects worth Rs 6.5 lakh crore are scheduled to be commissioned in 2010-11.
The momentum of investments is unlikely to fizzle out soon. This is evident from the fact that Rs 4.3 lakh crore worth of new investment proposals were announced during the quarter-ended March 2010. With this, fresh proposals are back to the levels they were before the 2008-09 crisis that temporarily halted fresh investment.
Easy liquidity and capital flows are likely to continue to facilitate this continued investments boom. More importantly, consumer demand is likely to continue to remain robust post the monetary policy statement. A large part of consumer spending in 2009-10 was because of the one-time effect of farm loan waivers and increase in wages of government employees. But, sustained growth in consumer spending is possible only when employment increases.
The sustained increase in creation of new capacities (which shows up as lower capacity utilisation in RBI studies) has also created new jobs. These new jobs (for which there is no official data) create new domestic demand. Given that external demand growth is expected to be weak, it is important that the domestic demand growth is sustained. A significant hike in interest rates by banks will hurt this growth in domestic demand.
Traditionally, Indian households have been very low on borrowing. The recent trend in banks lending to households for homes, consumer durables, automobiles, education and other expenses has spurred domestic demand. A hike in interest rates is unlikely to hurt the corporate sector?s cost structures or profitability directly. Corporates are flush with funds, have a strong balance sheet and command handsome profit margins. A hike in interest rates can be easily absorbed without impacting profit margins too much. Similarly, a hike in interest rates is unlikely to adversely impact costs involved in their expansion plans. It looks like they are on their way to get their pricing power back. But, if investments continue, competition will ensure that this power is under check.
Unlike the corporate sector, a hike in interest rates is likely to hurt domestic demand. Households are more sensitive to EMIs than corporates are to interest rates. A hike in interest rates can deplete the demand for housing. The interest-rate elasticity of demand for housing loans is evident in the teaser rates offered by some of the big banks to attract buyers. It is important to sustain this demand rather than curtail it. For if it is curtailed, it will bring down with it the investment demand that is in the pipeline. In India, domestic demand is the single largest determinant of investment demand.
Indian households are characterised by high savings, low per capita consumption levels and low borrowings, compared to international standards. A hike in interest rates would further increase their savings and depress consumption and borrowing. It makes sense to let households borrow more and increase their consumption levels. It makes sense to let the investment cycle continue and increase gainful employment. It makes sense to let the economy hum along without government interventions. If this leads to a consensus inflationary expectation of about 5-6% and a growth of 8%, it is a pretty good deal. Although I believe that we have a better deal on hand.
The author heads Centre for Monitoring Indian Economy