Is RBI's (in)action justified?

Yesterday, on June 18^th, the RBI in its mid quarter review, left key rates - including repo and CRR - unchanged. This has clearly disappointed the industry and stock markets, which were keenly expecting rate cuts to support sagging economic growth. With the country in Stagflation – a state of low economic growth and high inflation, the RBI must’ve been in a tough dilemma. The rule of thumb in economics is that lower interest rates encourage economic growth, while higher interest rates help slow down growth and thus control inflation. Having left key rates unchanged, the RBI has taken an anti-inflationary stance, rather than a pro-growth one. RBI’s statement seems to indicate that it believes that in the current scenario, interest rates will have minimal impact on reviving economic growth. RBI has sent out a clear message that it is for the government to do more to encourage growth through policy reforms.

There has been contrasting commentary in national media, both for and against RBI’s decision. The RBI (and those who support its decision to leave interest rates unchanged) has argued that the current stagnation in economic growth has little to do with high interest rates and that, reducing rates now will have little, if at all any, impact on spurring growth. It has pointed out that fiscal reforms and bold policy decisions by the government is needed to improve investor sentiment. Also, with inflation still stubbornly high and with the steep depreciation of the Rupee, RBI feels justified in not lowering interest rates.

Following are the main arguments of the RBI:

Need for fiscal reforms – Basically, RBI wants the government to take steps to reduce fiscal deficit and current account deficit. In other words, the government’s debt needs to be reduced. Today, the government is borrowing so much money, that a significant portion of all the money available with banks for lending are being lent to the government. And since the government is not making any surplus, its debt burden is getting bigger each year. So, every year a greater proportion of banks’ available credit is given to government. This is leaving banks will less money to lend to the private sector. This phenomenon is called “Crowding Out” of the private sector by the government. The argument is that, rather than reducing interest rates, the government should take steps to reduce its debt burden. This can be done by reducing subsidies and by selling state assets (disinvestment of PSUs). These steps will release more credit into the banking sector, which can then lend more to private sector industries, thus encouraging economic growth.

Addressing supply side constraints – Inflation can be driven by supply factors or by demand factors. This means that, either low supply or high demand will cause inflation. RBI feels that inflation in the current scenario is being caused more by supply side constraints. Examples include: Inefficient storage and distribution of food grains, Lack of cold storage and warehouse facilities leading to lot of wastage and losses, especially in vegetables, fruits, meat and poultry products. Sometimes the government’s MSP (minimum support price) policy leads to skewed production of food grains, where we see surplus wheat and rice production, but shortage in edible oil and pulses. Also, lack of infrastructure – roads, railroads and electricity – lead to increased cost of distribution of goods across the country. RBI feels that, if government takes steps to address these supply side constraints, the overall productivity and efficiency of the economy will increase. More goods and grains will reach the end consumer at a lower price, thus helping reduce inflation.

Minimal impact of interest rates on economic growth – The RBI states that effective bank lending rates today are slightly lower than during the 2003-08 period, when the country witnessed strong economic growth. Hence it argues that interest rates alone cannot be blamed for today’s low growth.

I am not an economist or an expert in financial matters. However, with my basic understanding of the subject and using my common sense, I present my take on this issue:

I agree to the first two arguments mentioned above. The government needs to take up fiscal reforms urgently, to ensure India’s macroeconomic health. Also, government should take policy steps to address supply side constraints. This will help bring down inflation in the long term. However, we’ve all seen that in recent years, the government has been unable to enact any major policy reforms. Without getting into the politics of the issue, let us for now accept that at this juncture, we cannot expect any big reforms from the government. We need to accept this as a fact. India’s fiscal scenario may not improve significantly at least until the next general elections, which is two years away. In this scenario, monetary policy is the only tool that can be leveraged to control the economy.

Inflation is definitely the RBI’s and the country’s biggest concern. In the past 5-6 years, price increases for the common man have been severe in food items like vegetables, poultry, food grains and fruits. This increase has been greater than the general increase in wage levels. Hence, inflation cannot be blamed purely on higher purchasing power. The problem lies in a lack of modern infrastructure for storage, transportation and distribution of food products. This systemic inefficiency causes huge loss of food production and reduced availability to the end consumer. Also, fragmented agricultural land ownership and lack of irrigation infrastructure and usage of archaic farming tools lead to less the optimum production. Hence there is a demand supply mismatch and consequently increased prices. The solution is obviously to build the required infrastructure. There is no other easy, short term solution to address the problem of food inflation. Building the required infrastructure requires a lot of money. One way to get the money is FDI. FDI in retail has been blocked due to political reasons. If we want to attract capital in agri infrastructure and core infrastructure areas, the least that can be done is lower interest rates.

If we have a loose monetary policy in this country, corporates will have greater access to capital. With more money available to them, corporates are most likely to invest in expanding their business. While this will create inflationary pressures, it will also help create more jobs. Sooner or later, cheap money will go to core infrastructure building activities. With government support, this should happen sooner. But even if government does nothing, money will eventually be deployed in building infrastructure. Again, this will create jobs. Eventually, with enough infrastructures in place, the country’s productivity levels will increase and help reduce the demand-supply gap that exists today. Infrastructure will also enable greater exports and will attract FDI. FDI will mean more money that can be deployed to further build infrastructure, thus establishing a virtuous cycle. Meanwhile, the slightly higher inflation will be compensated by the higher number of job creation.

My argument is that, in the absence of strong government policy making, the RBI needs to maintain a loose monetary policy. This is imperative for economic growth. Higher economic growth will create market pressures that are strong enough to eventually divert money and intent towards building infrastructure. Better infrastructure will be the key to resolve supply bottlenecks, boost productivity and ease inflation. High interest rates can be used to control inflation eventually. But it will also bring industrial activity to a screeching halt. This will significantly hurt jobs creation. With India experiencing a ‘demographic dividend’, it is extremely critical that our young population has enough jobs to occupy themselves. We will have to bear with the pain of inflation in the medium term, if it eventually results in an infrastructurally capable and vibrant economy.

There are numerous policy reforms and initiatives that are possible and should be enacted by the government to support economic growth. And we should continue to put pressure on the government on these issues. However, I believe we have a way out of this mess created by our politicians. And that way is monetary loosening.