By Kaushik Anand
Over the last week, there has been a lot written about Dr.Rajan’s departure from the RBI. Most of these have either used his pedigree to paint a doomsday scenario or attacked him using his US residency status. In this blogpost, I am not going to indulge in any of these irrelevant facts. The criticism raised and Dr.Rajan’s public responses have however raised some fascinating academic questions. The purpose of this blogpost is to explain arguments from both sides and to let you make your own decision.
Before getting to them, let us first understand what the RBI (or any other federal bank) really does.
Note: If you have a good understanding of monetary policy, you can skip the beginning portions and start directly at debate point 1.
What does RBI really do?
RBI’s (or any other federal bank’s) primarily role is to control the money supply in the economy. There are different ways to control money supply:
The simplest way is by printing or revoking money from the system. Printing more money increases money supply and vice versa.
Reducing or increasing interest rates (repo rates). This is the rate at which commercial banks borrow from the RBI. With lower interest rates, companies and people borrow more thereby increasing the money supply in the system. The reverse happens with higher interest rates.
Increasing or decreasing the statutory liquidity ratio i.e. the reserve requirement that banks need to maintain in gold, govt approved securities etc. By increasing this ratio, the RBI reduces the amount banks have left to lend and thereby reduce the money supply in the system. The reverse happens when they reduce the ratio.
Through open market operations by buying or selling government bonds. When they buy bonds, they push more cash into the economy and thereby increase money supply.
How does money supply affect inflation and growth?
Let us assume that RBI increases money supply through one of these means (e.g. reduce interest rates, print money, reduce SLR or buy govt bonds). For simplicity, let us just assume that this is the same as putting more money into the hands of consumers and businesses. This in turn means that people have more cash (used loosely, not cash in literal sense) in their hands. This then prompts people to go and spend more. Initially in a demand constrained economy, this ends up increasing economic activity. You buy more, more products gets produced, more jobs are created. However, when more money chases the same goods, eventually prices start to rise (inflation). So, as you increase money supply, it increases growth and increases inflation. If you decrease money supply, it reduces inflation buy also reduces growth, job creation and other economic activity. So, inflation and growth are tradeoffs which the RBI and Govt prioritize differently at different points in time. This is also the primary reason why monetary policy (RBI) needs to be independent from government policy. Given their way, any incumbent government can just increase money supply before elections and make people feel happy about having more money, more jobs and get re-elected. However, this ends up in inflation where prices of essentials rise and eventually needs to corrected with reducing money supply and growth.
Why is interest rate important?
Most of the debate has been around interest rates. So, let us delve a little deeper into it. Firstly, all the interest rates you see (FD, savings bank deposit interest, loan rates) are all eventually tied down to RBI’s interest rate plus some margins. So, if RBI reduces interest rates, it reduces the borrowing rates (for loans) but will also reduce savings banks and fixed deposit rates. So, when people complain about FD rates and PF rates they see going down, they are sometimes just wrong. The rates they see are nominal interest rates (at today’s prices). What should really matter are real interest rates (if prices were held constant).
Real interest rate = Nominal interest rate — inflation
So, if the FD interest rate is 9% and inflation is 7%, real interest rate is 2%. If FD interest rate is 7% but inflation is 4%, real interest rate is 3%. Real interest rate is the rate at which money really compounds. So, you are actually better off here in the second scenario. There is no reason to feel upset by simply looking at nominal interest rates from banks.
The fundamental debate in this instance is that RBI has not reduced rates enough to aid growth. The govt mandated target for consumer price inflation (CPI) is 5% and it has been hovering around that range for a few months now.
Debate point 1: RBI is holding back interest rate cuts looking at CPI instead of WPI
Till recently, wholesale price inflation (WPI) was the metric RBI would base its interest rate decisions on. So, when you kept hearing that inflation was under control but you kept seeing the price of dal go up, both RBI and you were right. WPI tracks the rise in prices of commodities and CPI tracks it at the consumer level and would include rise in prices of transportation, wages etc too. So, when commodity prices are low (like it is today), CPI generally exceeds WPI. The reverse happens when commodity prices are high. After the hue and cry about prices of essential food items going up, RBI’s inflation targets were set in CPI. So, today, RBI is making decisions based on CPI and that is higher than WPI today.
Rajan’s view: CPI is the real metric to look at since it affects the common man. Also, WPI can be higher than CPI when commodity prices go up. We are going by the target given to us.
Critic’s view: By looking at the higher of the two inflation metrics, you are being too cautious on interest rates. Supplier’s prices are only going up at WPI and not at CPI. So, by looking at CPI, you are essentially increasing borrowing costs for suppliers and hence reducing growth.
Debate point 2: Interest rate methods don’t work in a supply constrained economy
As discussed earlier, RBI only has influence over monetary policy (jargon for money supply). They cannot control how much food is available due to lack of monsoons, poor supply chain or some other factors. It is upto the government to manage it. So, interest rates have limited effect on food prices which is a major component on CPI.
Rajan’s view: While RBI cannot manage food supply, it can control prices of others goods (e.g. clothes) through interest rates. To prevent food inflation from turning into overall inflation, you need to have higher interest rates. He is essentially saying that he will use interest rates to ensure that overall household expenses will not go up significantly even if food expenses are going up.
Critic’s view: By trying to reduce overall inflation, RBI has essentially slowed down growth in other sectors (e.g. clothes) and not let the economy grow fast enough. This has led to slower job creation and other economic activity. If RBI focuses on WPI, they can prevent this to some extent. It is the govt that has to somehow figure out ways to solve the food inflation issue (either through imports or preventing hoarding or reducing minimum support prices).
Debate point 3: RBI has stalled industry by going after NPAs
NPA is when banks declare that a company has defaulted on its debt and will be unable to repay it. In the past, real interest rates in India have been negative (due to high inflation) making debt burden lower with time and banks (specifically PSUs) have been lending somewhat recklessly without due diligence on whether the companies can repay the loans. So, instead of recognizing that a company cannot pay, banks would lend more money to the company to repay interest on a previous loan. It is a win-win in the short term where banks would show better profits by not recognizing NPAs and the borrowers continue running business as usual. Obviously this can only work till a point even if the govt keeps bailing out PSUs because the government has a budget too. This also ends up benefiting business owners who can keep recycling their loans. Due to such reckless lending over the last 10–15 years, banks’s balance sheets are now in trouble. So, RBI mandated a clean up and recognition of NPAs. This means that those with NPAs (big businesses or SMEs) cannot borrow more from banks to repay interest on older loans or for new business activity.
Rajan’s view: The previous system benefited incumbents disproportionately and forced bad lending decisions. This has led to banks being in trouble. By forcing them to recognize NPAs, banks would finally try to get the companies to repay by selling off assets or other means.
Critic’s view: While NPAs could be a real issue, trying to solve for it hastily stalls business. For example, imagine that you are a distributor of a FMCG company. If the company says that you cannot continue to run your business unless you pay all your outstanding balances, it puts the supplier out of work. This is a simplistic example to show the problem here. While recognizing NPAs is the correct decision, it affects business activity and growth in the short term.
Debate point 4: Even though RBI reduced interest rates, banks are lending to SMEs at a much higher rate
As discussed earlier, banks borrow at the repo rate from RBI and then lend to companies at some margin. This margin is decided by the bank based on the riskiness of the project, ability to make interest payments and principal repayments.
Borrowing rate = Risk free rate (RBI’s rate) + risk premium (based on ability to repay)
Rajan’s view: The reason borrowing costs are high for SMEs or big businesses is not because of RBI’s interest rates but because the risk premium which banks place on these companies is high. This is because the companies in question have already borrowed too much and banks think any new loans are risky. So, they charge a higher interest rate to compensate for this risk.
Critic’s view: The problem is not with risk premium but with RBI’s rate. At the same risk premium, companies can borrow for cheaper if RBI mandated interest rates are lower and can hence have higher growth.
There have been many other points around credit access, housing loans, payment banksetc but the above four points seem to be the real points of contention around monetary policy. As you can see, on many of these issues, there is no right or wrong answer. We unfortunately cannot play out the alternate scenario. As long as the RBI continues to make independent monetary policy decisions, has a system in place to do it and has someone knowledgeable at the helm, Dr. Rajan’s exit does not mean disaster even if it means losing someone extremely talented at the helm.
Note:
Rajan’s view is from this speech he gave at TIFR. I have used a variety of critics (including Swamy) to present the alternate point of view.
This was first published on Medium and has been republished with permission.