Economy and stock market moving in opposite direction; time to raise bank rates, stabilise economy 

Indian economy is witnessing an amazing contradiction. Its growth rate in 2019 is among the lowest in the last two decades. But, its stock market is booming like never before. There is every reason to suspect that the situation is engineered. It has something to do with continuous lowering of bank rates by the central bank despite the fact that the policy has not helped raise production, demand, employment or lower inflation. The principal beneficiaries of the rate cuts seem to be punters in the stock market as public savings are getting systematically diverted from banks to the equity market.

Companies also benefited by using low cost funds to retire or substantially reduce high cost loans taken earlier. On December 31, 2018, the Nifty and Sensex finished the calendar year with high notes. The Sensex traded at 36,047 and the Nifty at 10,856. Almost a year later, on December 23, 2019, Sensex jumped up to 41,475 and Nifty 12,213, recording a huge gain over the respective indices at 2018 end. The market and punters made huge gains while the economy dipped from seven percent in 2017 to below five percent at 2019 end.

The prices of food articles and many consumer goods reached their peak in December. Why did lower bank rates failed to pep up demand for manufactured goods and real estates? Why is the banking system witnessing an ominously low deposit growth rate? Why are bank

NPAs rising? Generally, when interest rates are reduced, more people are able to borrow more money. And, consumers have more money to spend. Economy grows and inflation increases. Why is this general principle failing in India? Historically, Indian economy has fared well under a tight money policy. Why is the country’s central bank ignoring this practical aspect to repeatedly reduce bank rates? It may be time to raise interest rates to stabilise the market. Interestingly, the government seems to be rather more practical and cautious about maintaining the interest rates for ‘Government Bonds’ and postal small savings despite successive RBI rate cuts. The central bank wants the government cut small savings rates. However, as of now, the government has stuck to its decision to hold rates.

Even the Employees Provident Fund Organisation (EPFO) is in favour of holding PF return rates.

Contrary to bank rates, the union labour ministry notified 8.65 per cent interest rate on employees provident fund for 2018-19. The Government bond continues to carry 7.75 percent interest per annum. The tax free bonds carry six per cent interest. Investors get carried away by the effective yield on tax-free bonds which is much higher. In the 30.9 percent tax bracket, an effective yield is 11.86 per cent. For postal small savings deposits, interest rates vary from 6.90 per cent to 7.70 per cent. The interest rate for ‘senior citizen deposits’ upto Rs.15 lakh each carry an annual interest rate of 8.65 percent. Thanks to RBI’s successive rate cuts, fixed deposits with banks today range between five percent to 6.75 per cent per annum. RBI’s frequent rate cuts have neither helped the banks, nor the economy.

The demand and supplies of industrial products have reached a new low. Consumer demand is downward. Employment is shrinking. Yet, inflation is inching up. Unusual, isn’t it?

India's retail inflation for October breached RBI’s medium-term target of four percent for the first time since July 2018. RBI had predicted that food prices "are likely to moderate as winter supplies enter the market". But, food prices went up further in November and December. The country witnessed record prices of onion, potato and ginger. Inflation in October touched 4.62 per cent compared to 3.99 per cent in September. Inflation, as measured by the Consumer Price Index, was 3.38 per cent in October 2018. Food price inflation, which amounts to half of the inflation basket, increased to 7.89 per cent against 5.1 percent in September. Meanwhile, pulses inflation shot up to 11.72 per cent from 8.4 per cent and vegetable inflation jumped to 26 per cent from 11.4 per cent, month on month. The prices of farm products in November and December reached an all time high. For instance, the retail prices of onion varied from Rs.150 to Rs.180 per kilo, almost across the country.

The supplies and prices of food items repeatedly failed RBI projections.

While fixing rates, RBI may have relied more on theory and practices in developed economies such as the US, Canada, Japan and EU than the reality in India based on historical evidence. India's long term interest rate reached an all-time high of 13.96 per cent in May 1996. Effective interest rates for borrowers was around 18 per cent during most parts of 1980s. Overdraft rates reached 24 per cent. However, high borrowing and deposit rates made little impact on India’s economic growth. In fact, the country’s long-term GDP growth has steadily accelerated over the last 50 years, without any prolonged reversals. Thus, while the annual economic growth averaged 4.4 per cent during the 1970s and 1980s, it accelerated to 5.5 per cent during the 1990s and 2000s, and further to 7.1 per cent in the past one decade.

Going by India’s economic history and growth trend over the years, there is no need for RBI to adopt the western prescription of bank rates. An upward revision of bank rate may only help stabilise commercial banks and the market, comforting both depositors and lenders.

The fact is that in India, high inflation rates have always been combated by RBI with high lending rates. The inverse correlation between interest rates and inflation rates is rarely noticed here. More than lower interest rates, better and well spread monsoon have favourably impacted the economy and consumer sentiment. Obviously, the supply and demand for money alone is not determining the country’s economic growth and inflation trends. What is missing is the bullish consumer sentiment irrespective of irrational stock market behaviour. Bullish stock market is not helping the economy or government.