On 22 January, the USA’s financial markets opened
with yet more bad news. Bank of America’s had to
take $5.28 billion of write-offs largely due to
mortgage related paper, and make higher provisions
for future loan losses. Consequently, it’s
fourth-quarter net income (net profits) fell to $268
million, from $5.26 billion a year earlier. That was
an earnings drop of 95 per cent.
Then came the Ambac Financial Group, a major bond
insurer. It reported a $3.26 billion quarterly loss,
which took the company’s 2007 deficit to $3.23
billion. Stripped of its AAA credit rating, Ambac’s
business has been badly hurt by the fall in value of
the various sub-prime mortgage-backed securities
that it had guaranteed.
Two pieces of rank bad news coming out every third
or fourth working day has become normal in today’s
US financial markets. But it hurt, and was bound to
hit the market badly. Then US Federal Reserve
Chairman Ben Bernanke came on the scene and threw a
major lifeline.
After an unscheduled video conference the evening
before, the Federal Open Market Committee (FOMC)
voted 8-to-1 in favour of a huge 75 basis point cut
(0.75 percentage point) in the benchmark interest
rate — a week before the scheduled FOMC meeting, and
its first emergency reduction since 2001. Slashing
the target overnight lending rate from 4.25 per cent
to 3.5 per cent, the FOMC cited the need for
“decisive and timely”' action “in view of a
weakening of the economic outlook and increasing
downside risks to growth.”
While the Fed’s unscheduled cut is substantial —
coming as it has after the previous 50 basis points
reduction — the US will not be alone in lowering
interest rates. On the same day, the Bank of Canada
lowered its key interest rate by 25 basis points to
4 per cent and said that it will act again, if
needed, to shield Canada from the US slowdown.
Jean-Claude Trichet of the European Central Bank (ECB)
and Mervyn King of the Bank of England will be hard
pressed to follow suit. Without such cuts, the
interest rate gap between the US and Great Britain
as well as the Euro Zone will create arbitrage
opportunities, further appreciate the pound and the
euro, and worsen the outlook for Europe, which is
already showing signs of slowdown.
In fact, the general view is that, given the slew of
bad news from the US, a cut of 75 basis points is
not enough. Market watchers expect Bernanke to
announce another 25 basis point cut after the FOMC
meeting scheduled for 29-30 January.
What, then, should the Reserve Bank of India (RBI)
do on 29 January when it releases its Third Quarter
Review of the Annual Statement on Monetary Policy
for 2007-08?
Clearly, time has come for the RBI to cut interest
rates and, for good measure, ease up a bit on the
cash reserve ratio (CRR). Ideally, the rate cut
should by 50 basis points: the repo rate from 7.75
per cent to 7.25 per cent; the reverse repo rate
from 6 per cent to 5.5 per cent and the bank rate
from 6 per cent to 5.5 per cent. Plus a 25 basis
point reduction in the CRR from 7.5 per cent to 7.25
per cent. Here are the reasons why.
First, growth. It is now fairly certain that India
will achieve lower growth in 2008-09. My early
estimate is around 8 per cent — maybe a bit less.
The fall will be largely due to lower growth in
manufacturing as well as construction. Over the last
three months, the growth rate of Index of Industrial
Production has begun to show considerable volatility
and nascent signs of trending down. Construction
growth has slackened. In a milieu of a global
slowdown, the industrial sector will be struggling
to achieve 8 per cent growth over 2008-09; and
services, too, may take a hit.
If you were a US resident staring at 1 per cent
growth or less, you would rejoice at a large economy
growing at 8 per cent. But the fact is that India
needs higher growth on a consistent basis, which has
to be driven by industry and services. Nobody doubt
that our real economic fundamentals remain strong.
All the more, therefore, that they shouldn’t be
weakened by policy inaction. Maintaining growth at 9
per cent, thus, needs both monetary and fiscal
stimuli — especially now.
Second, interest rates. Irrespective of what
inflation number you fancy, the fact is that our
real interest rates are too high, and bear no
relation with those of our competitors. The prime
lending rate (PLR) varies between 12.75 per cent and
13.25 per cent; and deposit rates are no less than
7.5 per cent. Forget about the 200 big corporates
who demand big discounts to PLR. Spare a thought for
the thousands of smaller businesses who borrow at,
or over PLR. How can they compete at these rates?
Third, investments. With higher interest rates and
bans on external commercial borrowings, many
companies are either postponing their investment
decisions, or paring them. With the real sector now
running at full capacity utilisation, this is
something that we can hardly afford.
Fourth, the exchange rate. The Fed rate cut will
immediately open huge opportunities for interest
rate arbitrage. If this intensifies, it will swell
net dollar inflows and put needless upward pressure
on the exchange rate. Indeed, given that the ECB and
the Bank of England will follow the Fed, the
exchange rate could across the board. That would
really hurt manufacturing and service sector
competitiveness. Keeping the exchange rate in check
needs the RBI to drop rates as well.
Finally, inflation. I believe that the RBI’s stance
on inflation is more monetarist than warranted.
Given our infrastructure constraints, sustained
growth of 9 per cent will probably coexist with
5-5.5 per cent inflation in the shorter term. If
wage good prices are in check — over which the RBI
has no control — we should be fairly safe. Keeping
interest rates high and choking growth because of an
ultra-monetarist fear of inflation is the last thing
that we need today.
None of these arguments for reducing rates has to do
with stock prices. Its about the real economy —
looking after which is the RBI’s fiduciary
responsibility as well. Let’s pray then for the rate
cuts.
Published: Business Standard, January 2008