Thursday, June 21, 2012

Are rate cuts the only solution to India's growth?

When India's GDP growth came in at quite a low figure of 5.3% for the March quarter, expectations ran high that the central bank would surely cut rates. The Reserve Bank of India (RBI), however, thought differently and chose to keep the rates unchanged. The signal was clear. As long as inflation remained high, rate cuts were not on its agenda. Thus, the onus was clearly on the government to overcome its lethargy and get India on the high growth path.

The central bank's decision has had its share of supporters and detractors. And this has raised the question whether cheap money was the answer to problems of slowing growth? We believe not. One need look no further than the US and Europe to gauge the impact of a loose monetary policy. Indeed, the developed world has kept interest rates close to zero in an attempt to kick start growth. And this has majorly backfired. With unemployment reigning high and consumption not really taking off, low interest rates have hardly provided the stimulus that those countries had envisaged.

There are other reasons too. One is that the key to growth are savings. If savers are at the receiving end with interest rates that are below inflation, they may be forced to chase risky assets in search of higher returns, thus putting their capital at risk. As mentioned earlier, since the RBI has decided to keep status quo, it is now upto the government to make tough decisions such as raising diesel prices and cutting wastage. Further, at a time when the rupee is falling, the only way to compensate savers abroad wanting to invest in India is by keeping rates high. As far as businesses are concerned, companies typically focus on the extent of returns generated. Thus, businesses may not have a problemwith high interest rates as long as the returns are also good. The key here is to create a business environment conducive to growth and low interest rates may not necessarily be the only solution. Cheaper capital can impact job growth too. This is because companies may substitute capital for labour creating less employment for every rupee invested.

What all this eventually means is that the government will have to focus on growth through reforms, cutting down deficit and deregulation. Laying the blame on the RBI and making it the scapegoat for India’s economic problems will not achieve much.

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