High interest rate policy has killed growth, drastically reduced jobs, without making even a token dent on inflation.
After months of paralysis in which the government simply could not, or was not allowed to, face the challenge posed by India’s industrial collapse, Manmohan Singh took the bull by the horns and passed the most draconian reduction of subsidies attempted by any government since the 1990-91 crisis. With a projected consumption of 88 billion litres of diesel this year the five rupee increase in its price will reduce subsidies — budgeted or under-recovered — by Rs 44,000 crore.
The 12.5 per cent VAT on this sum will bring Rs 5,500 crore to the coffers of the state governments. The reduction in LPG allotment implied by the limitation of cylinder to individual allottees will reduce oil company under recoveries by another Rs 5,300 crore. All in all, these measures will reduce the overall deficit in Central and state budgets by more than Rs 55,000 crore.
But this brave effort, made in the teeth of populism and rank irresponsibility within its own coalition, has been sabotaged by another department of what is supposed to be part of the same government — the Reserve Bank of India. In his policy announcement, the governor, D Subbarao, justified his token quarter percent cut in the Cash Reserve Ratio by saying that in the current situation, ‘persistent inflationary pressures alongside risks emerging from the...current account and fiscal deficits’ constrained him from taking ‘stronger monetary policy action’.
The government’s disappointment was mirrored by P Chidambaram’s remark that ‘the response of the RBI on October 30 will be far (more) supportive of growth.’ Chidambaram was undoubtedly trying to forestall a slide in investor confidence, but coming from the finance minister this was only a hair short of an ultimatum.
Will Subbarao heed it? Or will he dig his heels in and set out to demonstrate the RBI’s independence as he did in July? The policy statement shows that he has left himself with ample room to do either, for it states ‘the stance of monetary policy (in October) will be conditioned by careful and continuous monitoring of the evolving growth-inflation dynamic.’
This obfuscatory language cloaks a simple dictum—the RBI will lower interest rates only if, in its assessment, inflationary pressures decline significantly in the next six weeks. Growth, in short, is of secondary importance. In a country where one third of those who are classified as ‘employed’ find work for less than seven days in a month, it is at least debatable whether inflation should trump growth.
But the RBI’s policy stance is even more inexcusable because, its high interest rate policy has killed growth and thrown millions out of work without making even a token dent on inflation. The RBI began to raise interest rates in January 2007 when the rate of inflation touched 6.5 per cent. By October inflation did drop to 3.2 per cent. But the entire decline, which began in June 2007, was a statistical illusion for, as many commentators pointed out at the time it sprang from the purging out of the 12-monthly data of the sharp rise in food prices, caused by an indifferent monsoon, between June and September 2006.
Spurted inflation
Between November 2007 and August 2008, despite continuing quarterly hikes in all policy rates that ended by taking the cash reserve ratio to an all-time high of 9 per cent , inflation spurted from 3.3 per cent to 12.8 per cent. Then came the global recession and the lack of correlation between monetary policy and inflation reversed itself. In a single stroke at the beginning of October, the RBI brought the CRR down from 9 to 6 per cent and further to 5 per cent in the next seven weeks.
Did prices spurt in response to this wanton profligacy? No, they fell with a huge thud to 3 per cent on February 21, 2009.
What did spurt was industrial growth. India shrugged off the global recession as if it did not exist. And beginning in October 2009, manufacture began to record a 12 per cent rate of growth. This began to falter only in August 2010, five months after the RBI began to raise interest rates once again.
Did this spurt in growth push up inflation? No, for on March 31, 2010 the rate of inflation stood at 3.7 per cent. So why, in precisely that month, did the reserve bank start to raise interest rates, citing the resurgence of inflation? The answer is a sharp price rise that began in December 2009 and crossed 10 per cent in February 2010. That was the beginning of 11 successive increases in policy rates that pushed up the average lending rate to borrowers by more than 3 per cent to their present astronomical high 10.5 to 15 per cent. This draconian credit squeeze has brought investment down by more than half in real terms in a single year—a feat that has no known peacetime precedent in the history of capitalism, and has led to an equally unprecedented shrinkage of industrial production in India for five straight months. But it has barely dented the rate of inflation, which is currently ruling at over 10 per cent.
Why has the RBI’s monetary policy failed so miserably ? The very short answer is that each and every change in the rate of inflation in the past five years has been triggered by supply shortages and surpluses caused by factors over which not just the RBI but the entire Indian government has no control.
The RBI’s obsession with fighting global cost push inflation by crushing domestic demand gets revealed for what it actually is: Ignorance of basic economics cloaked in outmoded dogma and defended with arrogant obduracy. Publicly the UPA government has joined the chorus of praise the RBI for what it did not do. But if it wishes to save the economy and its own chances of re-election in 2014 it would do well to persuade the RBI to see the error of its ways before October 30.
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