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Sunday, May 12, 2013

What Ails the Indian Economy?



Amid the global financial turmoil Indian economy too is reeling under pressure and the main reason being attributed for the same is higher borrowing cost arising due to higher prevailing interest rates.
Higher interest rates are badly affecting the profitability of Indian companies and forcing them to defer the capacity expansion which is a must for the growth of the economy.
Besides oversees recession, higher interest rates are responsible for the slowing of the Indian economy which is being reflected by falling GDP numbers.

Image source: tradingeconomics

RBI or Reserve Bank of India-the Indian central bank, controls the interest rates in the country by its monetary tools viz. Policy Rates and ReserveRatios.
One of the major constituent of policy rates is the Repo Rate – the rate at which the RBI lends to commercial banks. Reverse Repo Rate –the rate at which commercial banks park their excess capital with the RBI- has been fixed at 100 basis points lower than the repo rate.
1 basis point is equal to .01 percent.
Recently on May 3, 2013, RBI governor slashed the repo rate by 25 basis points to 7.25 % and thus Reverse Repo Rate got automatically calibrated to 6.25 %.
Banks are not only demanding for the further slashing of repo rate but they want CRR to be slashed as well.
CRR or Cash Reserve Ratio is the fraction of deposits that banks need to park with the RBI and no interest is payable on it. CRR too is expressed as a percentage.
The current CRR rate is 4 % that means all banks shall necessarily have to park 4 % of their deposits with the RBI and as there is no interest payable on it, it acts as an idle capital for banks.
Banks want RBI to slash the CRR along with the repo rate so that they can reduce the lending rates.
The other option available with banks is reducing the deposit rates and as banks are already short of the capital this option is not viable.
The reason for the shortage of the capital was due to the fabulous returns that Gold and real estate market generated in past several years pulling investors’ money from the banks and deprived banks of the capital. This is the reason responsible for the higher deposit rates of banks –a measure to attract the deposits.

Now the question is why RBI is not slashing the CRR and Repo Rate?

And the answer is -the fear of raging inflation. The RBI governor is very cautious about it and this is why he is not slashing the rates liberally.
The Indian economy is already under pressure due to the twin deficit- Fiscal Deficit and Current Account Defict (CAD). Higher CAD results in weaker currency and weaker currency further boosts the inflation. When CAD rises beyond a limit, credit-rating agencies downgrade the economy. Lower credit rating means newer debt at higher cost and this is how economy goes into a negative spiral.

Is there any silver line?

The recent fall in Gold was a great solace for the Indian economy as the same helped to tame the increasing twin deficit. In coming years, with more and more power plants adding capacities more imported coal shall be required which might aggravate the deficits.
Indian government needs to decontrol the diesel prices fully and major subsidies (oil, fuel & fertilizer) should be transferred directly into the Aadhar linked bank accounts of beneficiaries so that only genuine and needy people get benefited.
Government should also cut down on its expenses in the name of populist measures. Higher government spending increases the CAD and is responsible for higher interest rates in the economy as it renders lesser borrowable money in the system for the businesses.
The oncoming food security bill is supposed to give food security to 65-70% of the population while only 33 % of people in India live below the poverty line and only these people should be given benefits of this scheme.  In the backdrop of employment guarantee schemes there was no need of extending the benefits to 65-70% of people and unnecessarily strain the economy.
To bring back the Indian economy back on the track a lot of reforms need to be done but having a look at the present political scenario it seems difficult.

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