Real interest rates have declined

India Inc often blames the RBI’s refusal to lower key interest rates for the current slowdown in industrial growth. But, in its latest annual report for 2011-12, the central bank has made it clear that even at current levels, the real effective lending rates of banks are relatively lower than their pre-crisis levels.

“The fact is that real lending rates have secularly declined since 2003-04,” the report states, highlighting an exercise undertaken by the RBI to calculate the weighted average lending rate (WALR) of scheduled commercial banks.

The study suggests that the effective lending rate in nominal terms increased to 12.7 per cent in 2011-12 in response to monetary tightening. This was slightly higher than the average 12.4 per cent in the pre-crisis period.

Fall in lending rates

What is more, while the real (net of inflation) WALR increased moderately to about 3.8 per cent in 2011-12, it remained lower than the average of about 7 per cent in the pre-crisis period of 2003-04 to 2007-08, when an investment boom was underway. The fall in real lending rates in the post-crisis period is even sharper if GDP deflators are used to calculate inflation, instead of the WPI, the RBI argues.

The RBI indicated that monetary policy can have strong impact on inflation, but its influence on output is more limited to nudging growth toward potential. It cannot bring about permanent or long-term changes in the levels of output, which are mainly driven by technology, productivity changes and fiscal policy.

The RBI also underlined that its primary concern will always be the adverse impact of high and persistent inflation, even though a slowdown raises unemployment and lowers income and consumption.

It argues that these changes are more pronounced in the organised than the unorganised sector, whereas a rise in inflation hurts across the board, acting like a regressive tax.

Monetary tightening and growth

India recorded growth of about 8.4 per cent in 2009-10 and 2010-11, but witnessed a deceleration to 6.5 per cent in 2011-12.

Growth of 5.3 per cent in Q4 of 2011-12 was the lowest in 29 quarters and in the first quarter of 2012-13, it is expected to be even lower.

But the RBI was more concerned with sticky inflation — which was at 9-10 per cent in each of the first eight months of 2011-12 — hiking operational policy rates by 525 basis points from 3.25 to 8.5 per cent between March 2010 and October 2011. However, it slashed the rates by 0.50 per percentage points in April, 2012. It also hiked the Cash Reserve Ratio (CRR) twice, increasing it by 100 bps from 5 to 6 per cent of NDTL.

Given these measures, there has been a perception that the Reserve Bank’s monetary tightening has been predominantly behind the growth slowdown. But the RBI says the initial rounds of increase were more in the nature of normalisation of policy from its crisis-driven excessive accommodative stance, which could not have had an adverse impact on growth.

Furthermore, even at the current level of policy rates, the real effective lending rates are relatively lower, which underlines that policy rates alone cannot explain the sharp growth slowdown in the last few quarters.

Inflation gap

It said interest rates are only one of many factors in investment decisions, which in any case depend on the rates over several cycles. While higher interest rates in 2011-12 may have affected investment, they are clearly not the primary reason for the downturn, it argues. Rather, the decline in investment was linked to global and domestic uncertainty, structural constraints, loss of pro-reform policy momentum and persistent inflation.

The central bank also noted that monetary policy is framed on several considerations, of which inflation and growth are the main ones. In this regard, headline inflation was at 9-10 per cent in each of the first eight months of 2011-12, way above the comfort level of 4-5 per cent. As such, it asserts that the inflation gap (actual vis-à-vis intended level of inflation) far exceeded the output gap (actual versus potential output).

These gaps cannot mechanically determine the policy setting, but constitute an important consideration in calibrating the policy response it said, warning that premature easing could have caused inflation risks to rise, thereby affecting growth over the medium term.

> arvind.jayaram@thehindu.co.in

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