Prof. Jayanth R. Varma’s Financial Markets Blog

A blog on financial markets and their regulation

India in a ZIRP world

I wrote a column
in the Financial Express today about why Indian interest
rates need to come down much more when the world interest rate is
going down to zero.

While discussing the magnitude of interest rate cuts in India
– the RBI cut repo rate and reverse repo rate by 100 basis
points each and CRR by 50 basis points on Friday – we need to
remember that the entire developed world appears to be converging to a
zero interest rate policy (ZIRP). This is a completely unprecedented
situation and points to interest rates much lower than what we are
accustomed to seeing.

India is an open economy and even the capital account is quite open
for all practical purposes. Indian interest rate policies are
therefore strongly influenced by global interest rate. A comparison of
the Indian repo rate and the US Fed Funds Target since 2000 shows that
Indian tightening and easing follows US tightening and easing with a
lag. Essentially, an open economy forces the RBI to follow what the
“world central bank” does; and the only flexibility that
it has is to delay its response by a few months.

Now, the US has pushed its interest rate down to virtually
zero. Japan has also done the same, and the European Central Bank is
also being dragged down that path much against its wishes by the sheer
strength of global forces. In that situation, how low should Indian
interest rates go?

plot

The plot above shows the spread between the Indian repo rate and
the US Fed Funds target with key tightening and easing episodes
demarcated on it. Because of the lag between US and Indian central
banks, this spread fluctuates a lot.

For example, in July 2006, the US had completed its tightening
cycle and India was still half way through its tightening cycle. The
spread between the two rates fell to an abnormally low level of
1½% with the Fed Funds target at 5¼% and the Indian repo
rate at 6¾%. Over the next nine months, India tightened by
another 1% to 7¾% while the US rate remained unchanged at
5¼%. In April 2007, with both central banks having completed
their tightening cycles, the spread was 2½% which can be
regarded as a “natural” spread between the rates in the
two countries reflecting differences in the respective inflation rates
and other structural characteristics of the two economies.

In September 2007, the US began easing interest rates in response
to the financial crisis. At that time, the crisis in the US appeared
very remote to us, and India left rates unchanged for several
months. Then earlier this year, the RBI raised interest rates by
1¼% to 9% in response to the inflation scare which gripped the
country at that time. The spread between US and Indian rates rose to
an extraordinary level of 7½% in October 2008.

Since then, India has been easing more sharply than the US and the
spread came down to 6½% by the end of 2008. But this is still a
very high spread. If we consider the April 2007 spread level of
2½% as a “natural” spread, then the Indian repo
rate needs to come down to well below 3%.

That is a much steeper cut than what RBI has made. But even that
might be an underestimate of what would be needed. The US has gone
beyond zero interest rates to a regime of quantitative easing which
pushes long rates down to low levels. Since it is not possible to make
interest rates negative, quantitative easing achieves the same effect
of negative interest rates by expanding the balance sheet of the
central bank.

This means that to achieve the same spread against the
“effective” (quantitative easing adjusted) interest rate
in the US, Indian rates would have to come down even more. Similarly,
European interest rates are lower than what they appear to be because

the expansion of the ECB balance sheet has some of the characteristics
of quantitative easing.

I believe that the RBI should cut its interest rates very rapidly
to a level consistent with global interest rates for four
reasons. First, the prospect of further cuts in rates in future makes
long term government bonds a one way bet – they are today the
most attractive asset for any bank on a risk adjusted basis. There is
no point exhorting banks to lend when the central bank rewards
“lazy banking” through the gradualism of its interest rate
policy.

Second, India can afford a fiscal stimulus only if interest rates
have first been brought down to very low levels. Otherwise, the weak
fiscal capacity of the state is wasted on paying an excessive interest
rate on its borrowings.

Third, the weakening of the currency caused by low interest rates
is a stimulus that the economy needs very badly.

Finally, since many economists now project inflation at 2% or so by
the end of this fiscal year, steep rate cuts are needed to prevent
real interest rates from becoming excessive.

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