By Syed Zahid Ahmad,
The recession in the US and prevailed uncertainty in the petroleum producing nations had provided an opportunity for India to pull capital resources from the US and Gulf countries, but the practical approach of RBI has converted the opportunities into challenges as the liquidity and inflation are certainly not under the control of the RBI which is attempting to freeze the liquidity by increasing the interest rate and cost of credits. FICCI and the corporate sector have already criticized RBI’s recent announcement to increase the rate of interest.
With the trend of increased capital inflow to India, the aggregate deposits by Scheduled Commercial Banks (SCBs) have increased from 80.7% in 2005-06 (Rs. 21,09,049 crores) to 102% (Rs. 31,96,939 crores) of GDP at factor cost by 2007-08. With increased deposits, the bank credits have also increased from Rs. 15,07,077 crores in 2005-06 to Rs. 23,61,914 crores by 2007-08 reflecting 75.6% of GDP at factor cost in 2007-08 as credit against 57.7% in 2005-06. This indeed is a situation; where our economists and financial sector regulators need to review the policy and practices adopted by RBI as we hardly evaluate the multi level impact of interest in our economic process.
The theory of J. M. Keynes has failed to guide us optimizing the growth opportunities with abundance of FDI. The practical approach of RBI to curb the rate of inflation by increasing the rate of Repo Rate and CRR for last 24 months (since July 2006) is not controlling inflation instead leading towards stagflation as the prices are continue to increase, but the expenditure, investment and net GDP growth rate is falling.
By increasing the Repo rate and CRR, liquidity might be freezed for shorter period, but it will increase cost of credit and output which inflates the GDP value. Since July 2006 RBI is increasing the Repo Rate and CRR, but inflation is also increasing. Interestingly the interest income to SCBs was Rs. 1,85,384.9 crores in 2005-06 which increased to Rs. 2,37,271.14 crores by 2006-07. It means by 2006-07 total interest income to SCBs was 7.1% of GDP at factor cost. It simply means that the interest income to SCBs has inflated the value of GDP at factor cost by 7.1%.
With increase in rate of interest, the aggregate deposits might increase and SCBs may need to pay more interest over increased deposits. Total interest expended by SCBs over deposits was Rs. 89,742 crores in 2005-06 which increased to Rs. 1,20,261.08 crores by 2006-07 showing a net annual increase of 34%. This growth is inflationary as it increases the buying capacity of the depositors. By 2006-07, the interest expended over deposits was around 4.20% of GDP at factor cost.
If we add the interest income of SCBs to interest expended over deposits, it stands for around 12.5% of GDP at factor cost and 8.6% of GDP at market prices in 2006-07. Considering the impact of interest on inflation, we may need to add interest income of SCBs through investments/ commercial credits with interest expended by SCBs over deposits. This amounts to approximately 9% of GDP at factor cost and 5% of GDP at market prices in the year 2006-07 while annual rate of inflation was 6.7%. It reflects that basically inflation is a result of interest charged on credits expanded by SCBs and interest expended over deposits. The interest charged by SCBs increases the cost of GDP and the price levels, while the interest paid by SCBs over deposits increases the purchasing power of the depositors. Both ways the interest is increasing the price level and causing inflation. Since RBI regulates the banking business in India, by increasing rate of interest it is increasing the inflation and decreasing the real term growth rates.
Further to note that RBI is increasing the rate of interest for over one year to control the inflation which ultimately increasing the cost of GDP showing higher GDP value and increasing inflation instead of controlling it. Our total final consumption expenditure as % of GDP at market prices is already declining from 67.8% in 2005-06 to 65.5% by 2007-08. This decline along with inflation cannot be controlled by increase in interest rate. This economic tendency may lead to stagflation which is more dangerous for economic stability and growth. RBI should review its policies and practices to monitor liquidity, credit and inflation, if we have to combat inflation and attain desirable growth rate.
Often it is argued that inflation devaluates the money and interest over deposits compensates its money value, but this argument is missing to note the cruel problem of inflation which arises due to interest and could be worse off with more interest over deposits.
Islamic economic ethics suggests mechanisms for stable and anti-inflationary monetary system which should be adopted by RBI to make our monetary system more stable and anti inflationary. Hope the RBI will consider these ethics as measure to combat inflation and stagflation.
Islamic Banking principles and practices will not only increase the equity deposits and finances but also promote capitalization and investments. It will help increase employment and business opportunities which are must for inclusive and foster growth of India at a time when the entire world is eying the Indian economy for making more investments. Otherwise consistent approach of RBI to control inflation through interest rate may let the UPA government at the Centre face cruel failures in capitalizing the investment and growth opportunities with worst off inflation and stagflation.
(The author is attached with AICMEU’s Baitulmal Co-op. Credit Society Ltd. (Mumbai. He can be contacted at [email protected]).