Ever since the first of three increases in the Cash Reserve Ratio (CRR) by the Reserve Bank of India (RBI) in last January, I have been using these columns to warn readers that the RBI was needlessly cutting short the first industrial boom in twelve years, and driving the country into recession. It was needless because the excuse given for the tightening of money supply – the need to control inflation – was utterly false.

While inflation (according to the Wholesale Price Index) had increased from 3.5 per cent for the year on April 22, to 5.7 per cent on October 21, two thirds of the difference of  2.2 per cent was accounted for by a 7 per cent jump in the rate of increase in the prices of primary products, i.e mainly food articles, fruits and vegetables. These are dependent entirely upon the weather and cannot be controlled by tinkering with interest rates or the money supply.

Of the remainder 1.1 per cent was accounted for by the rise in international oil prices, again something that choking the money supply could not possibly affect. The core rate of inflation – i.e the rise in prices that the monetary policy could curb, was just over three per cent. India, in short, was not suffering from significant internally generated inflation.

By April, the WPI-based inflation had spurted to 6.1 per cent but once again, a full 2.7 per cent of this was contributed by the 12.1 per cent rise in prices of primary products, nearly all of which had occurred the previous summer.

But industry was entering a boom and the prices of manufactured products had begun to rise somewhat. So the ever eager RBI raised the CRR again and took another Rs 15,000 crore out of the bank deposits available for financing credit. Within days the prime lending rate was a full two per cent higher than it had been a year earlier.

Three months after the second CRR hike, all the outliers of the recessionary storm that is approaching are visible to the unjaundiced eye.

The price of real state is falling; upto Rs 800 crore of housing loans have already gone bad and been sold off and more is likely to follow; anticipating a glut of apartments and houses on the market and fearful of the high interest rates, builders have put new projects on hold ; there has been a 15 per cent drop in the sale of two-wheelers in the first quarter, a smaller decline in the sale of commercial vehicles and a massive shift  from larger to smaller cars in the “non-executive” class of automobiles.

Bank advances have shrunk by Rs 33,000 crore almost entirely in the non-food commercial sector. Most of this reflects a fall in consumer credit. High interest rates have triggered an inflow of dollars, pushed up the rupee by 14 per cent, and severely hurt export earnings. The BPO industry and garment exporters are in a panic.

Anyone who cared a fig for economic growth would have lowered interest rates. The banks were wallowing in funds for which there was no demand. One small signal from the RBI would have made them cut rates. This might have aborted the gathering momentum of recession. But against all reason, the RBI has chosen simply to mop up the surplus cash with the banks by raising the CRR once again.

Governor Y V Reddy’s excuse is that he has to mop up the increase in money supply caused by the huge inflow of dollars. What he prefers not to remember is that it is his increase in interest rates to levels completely out of line with the rest of the world that is pulling the dollars in. Sterilising the resulting increase in money supply will only perpetuate the inflow of dollars on the capital account. 

What he also seems unmindful of is the way in which the high exchange rate has doubled the balance of payments deficit on the current account. This is exactly what happened in Thailand for more than a year before the crash of 1997.

When a decision makes no economic sense one must start looking for political motivation which is not hard to find. Unlike other years the rise in interest rates has not completely blocked investment. What it has done is to divert a good part of it abroad.

Since Indian interest rates have always been a good deal higher than those in the global financial market, Indian firms have been borrowing abroad ever since the Vajpayee government opened the sluice gates in 2004.

However in the last two years this borrowing has increased dramatically. In the first three months of 2007, total net medium and long term borrowing by private firms  jumped further to $2.1 billion a month.

A close look at the borrowers shows that the bulk loans have been taken by a handful of very large companies or groups. But all of them are dwarfed by the two Reliance groups. Between April 2006 and March 2007, these have raised a total of $7.775 billion dollars worth of loans.

This is just under half of all the private borrowing abroad between April 2006 and March 2007. More than a third of this was raised in February and March 2007, after  Mr Reddy’s first CRR increase.

These are all first class borrowers who are more than capable of earning the foreign exchange needed to service their debts. But the fact remains that they, and a small class of brokers and inside traders on the stock markets, are also the only beneficiaries of the suicidal policy that Y V Reddy is pursuing today.