Yesterday, on June 18th,
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.