3 i’s : INFLATION, INTEREST AND IMPACT

[Dr. Sanjiv Agarwal]

The Reserve Bank’s credit policy review in last week of July 2011 came with a shock to general public when RBI raised short term rates (repo rates) to 8 percent from 7.5  percent, just to curb  inflationary pressures.

The first and major outcome  of rate hike by Reserve Bank of India is that all major banks have liked their interest rate on advances and loans by atleast 50 basis points, which comes into effect from 1^st August, 2011 . The hike in the base rate for  loans as well as benchmark prime lending rate  (BPLR) implies that credit will become costlier leading to increased cost of production and higher prices,  only adding further to inflation. The prices are not going to come down. This will also adversely  affect the demand and production.

However, RBI strongly believes that rate hike is necessary to check inflationary pressures but somehow it is not working. India is today struggling with growth inflation dynamics  and have to decide between faster growth and checking inflation at the cost of growth (in short term). While sacrificing growth for the time being could be a better idea but will inflation be curbed with rate hike alone is a big question before us as it is not giving the desired results since last so many quarters.

If the banks do not increase the interest rates, the pressure mounts on the bank’s bottom line as their margins are shrinking . The rates are hiked to manage and maintain net interest margin. Apart from having adverse impact on industry in general which has also been endorsed by stock markets, the interest rates will effect the loan portfolio of banks, more so in the housing, auto and personal loan segments. This may in turn leave lesser amount available in the hands of a person who has availed such loans owing to higher EMI.  Not only this, demand for such loans would come down causing concern to auto industry, consumer durable sector and real estate, which is already passing through a bad patch. In fact, real estate sector in going to be worst hit with depleting sales, increased cost of funds, service taxation and banker’s perception about this sector. Another reason for interest hike which is the off shoot of RBI policy rate is the corresponding increase in deposit rates adding to the cost of funds. Thus, borrowers are on the receiving end and shall certainly feel the pinch and their advances portfolio will come under stress. While RBI’s focus is to have tight monetary policy and contain consumption, it is just not happening despite continuous rate hike in last over a dozen quarters.

Higher interest rate is also going to kill the festive fizz as it will affect demand and buyer’s mood as the forthcoming festive season, peaking around diwali is going to have a dampened mood because of higher borrowing costs, coupled with skyrocketing prices of gold & silver. It is worth mentioning that loan rates of automobile loans and housing loans have been raised about a dozen times in almost same number of quarters. The car and two wheeler makers, as also the real estate people are going to suffer the most, next to the common man. 

But RBI’s rate hike is not having any impact on rising inflation due to lack of support from other quarters. Increase in support price of certain commodities and increase  in prices of various petroleum products have also added to inflation. Country’s economic growth would also hamper if we do / not curb  inflation and the interest rates continue to go north wards like this. Interest rates may also result in more doubtful or bad debts for the banks, thus affecting their asset quality. Presently, gross NPA ratio in banks is about 2.30 percent which may cross 3 percent by year end. Adding to it, new credit off take would also be adversely  affected.

This RBI’s hike of 50 basis points faces dismay and dissatisfaction. Small businessman and companies are already under the interest rate fever and this will certainly impact them. While larger corporates may be able to tap cheaper external borrowings and foreign currency finds, smaller companies are deprived of this source. The overall impact could be in the form of deferred expansion plans, delayed projects, slowing consumer demand, cost of production going up, use of own sources to meet business needs etc.

The crackdown on inflation is desired but we need to look at some other perception as the RBI’s address to the problem is just not working. With festival season ahead, will the demand come down?  Perhaps no. If RBI’s stance is rigid, we should be prepared for another rate hike which many bankers and even the Finance Ministry do not rule out . With slow economic growth foreseen in near future, a call needs to be taken between moderate inflation vis-à-vis economic growth. With a vast and nature pool of economists, bankers and even the prime minister being the economist himself , it is hoped that solution is possible.

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