The RBI has been managing interest rates at levels lower than warranted all through this cycle (since recovery began in 2009). This can’t go on, says Morgan Stanley

A rise in real rates in India will be inevitable considering the outlook for US real rates and the US dollar. The key to risk asset performance will be the government’s policy reforms to reverse distortions in the price of land, labour, and capital, improving the productivity dynamic and helping GDP growth to accelerate by supporting a rise in the ratio of investment to GDP. This will be critical to bring back the virtuous circle wherein real GDP growth is much higher than real interest rates. This is the observation of Morgan Stanley analysts in their research note on rising interest rates and its effect on GDP growth.

Morgan Stanley argues that the RBI has been managing interest rates at levels lower than warranted all through this cycle (since recovery began in 2009). A central bank’s dharma is to provide the appropriate counterbalancing force in the overall economy to achieve optimal growth and inflation outcomes for maximization of economic welfare.

On the recent decision of the RBI to increase interest rates, Morgan Stanley feels that it is the correct thing for the economy. Though private investment did not respond to low real rates, the RBI's accommodative monetary policy gave the government continued support to run a high fiscal deficit – one of the key factors behind high inflation. While high government deficits meant a decline in public saving, negative real rates for savers caused a further decline in household saving. As savings declined faster than investment, the current account deficit kept widening. In the context of the government's inability to quickly augment public saving by aggressive pro-cyclical fiscal tightening, hiking real rates was the only credible way to demonstrate a commitment to reduce the saving-investment gap.

The Morgan Stanley research note in its conclusion says that even as we expect saving to rise and investment to slow over the next 12 months, the current account will still be in deficit (i.e., India will still be short of saving). Hence, trends in US real rates/the US Dollar will remain the key driver of domestic real rates. “We thus believe the key will be to lift real GDP growth with policy reforms and change in expectation of the returns on investment for entrepreneurs by systematically addressing the issues related to the business environment,” says Morgan Stanley.

On the other issue of inflation, the government must take policy decisions to improve on all the factors driving inflation upwards, which include: (a) aggressive government spending (largely revenue in nature); (b) a large, sustained increase in rural wages (largely reflecting the externality of the national rural employment scheme) and (c) higher global commodity prices, particularly oil, at a time when India's mining sector output was constrained (d) negative real rates for savers.