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Suresh Krishnamurthy

THE Reserve Bank of India Governor's refusal to signal a further reduction in interest rate must come as a relief to investors. Importantly, Dr Bimal Jalan has also said that he is waiting for clarity on the monsoon and inflation scenario.

This is good news as the link between inflation trends and interest rate trends has been missing for some time now.

Re-establishment of the link is necessary to save investors from being battered by declining yields on investment and rising inflation.

No justification: The clamour for further reduction in interest rates have their origin in the reduction in a key rate effected by the Federal Reserve of the US. Interest rates in the US have since declined to a 45-year low. In addition, some central banks of the East Asian countries responded with an interest rate cut of their own.

This led to expectations that the RBI will follow suit. The RBI has, however, responded saying there is no urgency to cut rates now.

In India, a justification for such a cut does not exist. Interest rates in countries such as China, Thailand and Singapore are much lower than they are in India. However, these countries are also dealing with benign inflation. In fact in Hong Kong and Singapore, strong deflationary pressures exist. With benign inflation, even if the interest rates are low, investors eventually get a good deal.

Inflation tends to reduce the real returns to investor. In simple terms, the real return to an investor is the difference between nominal interest rate and the rate of inflation. In other Asian countries where interest rates are lower than in India, the difference between nominal interest rate and the rate of inflation is higher than in India (see Table).

This is because inflation in India is as strong as ever. Inflation based on the consumer price index is now above 4 per cent and the target for the year is 5-5.5 per cent. With such inflationary pressures on hand, a reduction in interest rate does not appear warranted.

Wealth transfer: For close to a year now, the link between interest rates and rate of inflation has ceased to exist. As inflationary pressures mounted, the speed with which interest rates declined accelerated.

As inflation gained speed from about 2 per cent to the level of more than 4 per cent, yield on the benchmark 10-year government security descended from above 7 per cent to less than 6 per cent. Predictably, this can only lead to lower real returns to the investor.

Lower real returns also means that wealth is being transferred from the investor to the borrower. Since the Government is the major borrower, wealth is partly being transferred from the citizens to the exchequer. In effect, the lower interest rates are acting as a form of indirect tax.

If the situation should not deteriorate further, the link between interest rates and inflation needs to be re-established. A reduction in interest rates from present levels should be resorted to only when the outlook for inflation is benign. Inflation should decline to levels close to 2 per cent before further cuts are affected.

In this context, the RBI Governor's statement, that he is looking for clarity on the monsoon and inflation fronts before cutting rates, is encouraging. However, investors need to be watchful. The embarrassment of riches vis-à-vis foreign exchange reserves may not leave the RBI with any option.

If the surge in forex reserves continues apace, the system will be awash with liquidity. Then a rate cut might happen even before inflation is tamed.

As such, investors need to retune their portfolios assuming real returns from debt securities will continue to be lower than in the past. This will require enhancing annual savings to meet investment objectives. There may be no other option left.

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