The Reserve Bank of India has – once again – refused to lower interest rates.
Marketmen are a bit miffed. They had hoped that such a move could have spurred the stock markets to even greater heights. It might upset the finance minister who hoped that an interest reduction could nudge more investments into India, which in turn could create jobs.
But look at the predicament facing the RBI governor.
Most economists agree that governments -- the world over -- can either control interest rates or currency rates (against the dollar). But they cannot control both. At least not for very long.
The reason is simple. If a currency is undervalued -- like the rupee is -- it helps exporters and makes imports more expensive for the country. But it also puts pressure on the local currency to become as weak as the government claims it to be. One way in which equilibrium can be reached is by inflation rates going up. Higher interest rates 'devalue' the local currency.
Since the government wants a weaker rupee against the dollar to encourage exports, inflation is bound to remain like a coiled spring, waiting to pop out as soon as the controls are removed. High interest rates are one form of control that the RBI uses to keep the lid on currency exchange and inflation rates.
On the other hand, if the inflation rate is 6%, is it unfair to want to give small depositors at least a percentage more than the inflation rate? That is the only way the government can ensure that retirement and pension benefits are not eroded, and savings that the government wants to encourage so very badly do not take a hit.
Obviously, then, lending rates have to be a notch higher than deposit rates. And the spread between the two is the money that banks need to finance their operations. Banks also need to make a bit of additional surplus so that they can make good the sticky loans dispensed during the UPA regime.
That leads us to the next question. How weak is the rupee really?
One good way of judging this is by comparing per capital GDP with per capital PPP (price purchase parity (see table). The smaller the difference between per capita GDP and PPP, the more realistically valued the currency is. The huge difference in the case of India tells you that the rupee has been 'compelled' to remain weak. Its actual price purchase parity is almost four times higher.
Inflation would have been higher, had India's inherent productivity been weak. But productivity is on the upswing, as is evidenced by the recent increase in the PMI (purchasing managers index). Add to that the increase in foreign direct investment and investment inflows. All these should have made the rupee stronger.
Had the rupee been allowed to become stronger, the RBI would have had a good case for lowering interest rates. But it would have hurt exports, and made imports cheap. That could have hurt the current account deficit, right!
As things stand today, the situation is volatile. Either the rupee will strengthen, or inflation rates will climb. Naturally, the only thing the RBI can cling on to is interest rates. But not for long. Something will give way.
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