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Context
- The Reserve Bank of India’s decision to lower the repo rate was a move in the right direction.
Importance of repo rate?
- The repo rate is the interest rate at which banks can borrow money from RBI for short durations.
- It stands to reason that, if this is lowered, banks can lend to their borrowers at lower rates.
- This is the reason why changing this rate usually influences interest rates across the economy and in the same direction.
- Raising the repo rate lowers inflation but also confines growth, while lowering it pushes up the growth rate but fuels inflation.
- India’s inflation has been falling over several months and is now well below 2 per cent.
India’s risk of low Inflation
- India now has a risk of sustained low inflation, which we know from the experience of other countries, most notably, Japan, can cause overall stagnation.
- As a result of the liquidity crunch associated with last November’s demonetization, overall GDP growth in India is now down to 6.1 per cent per annum.
- India’s investment-to-GDP ratio had risen since 2003 and was holding steady at above 35 per cent.
- This was a major factor fueling the country’s high growth. This has now dropped to approximately 28 per cent.
- The positive relation between how much money a country allocates to investment, especially in long-run infrastructure, and how fast its GDP grows is one of the more enduring findings in economics.
- If one of these countries raises interest rates, in today’s globalized world, money will flow into the country from the other economies in order to earn the higher return.
- And as more players try to buy this country’s currency to invest in it, the currency will appreciate, causing exports to suffer.
- India is erring by holding on to high interest rates, it is attracting capital flows into the country, as evidenced by the large foreign exchange reserve held by the Reserve Bank.
- This is causing the rupee to be stronger than it should be and this is, in turn, stunting exports, and also growth.
