Economic Harakiri

Indias self-inflicted wounds

The surest way to revive investment and hire purchase financing is to bring down interest rates by around 3 per cent.

From 8.2 per cent to 2.8 percent! That is the fall in industrial growth that has taken place in a single year, between 2010-11 and 2011-12. The neat reversal of numbers makes one wonder if there is not, indeed, a puckish God somewhere ‘up there’ having a belly laugh at the expense of our clueless government. Terrible as it is, this year-to-year decline does not tell us the worst part of the story which is the colossal contraction of 12.9 per cent in the rate of industrial growth between March 2011 and March 2012. For, while industry had grown by 9.4 per cent  in march 2011, it has contracted by 3.5 per cent in March this year. And to fill our cup of woes, the rupee has depreciated by a full 25 per cent since last September.

Who, or what, is responsible? If we are to believe the Reserve Bank of India it is the global recession, the financial turmoil in Europe, the stubborn high inflation and the swollen fiscal deficit, everything in short, except its own monetary policies. It has taken the collapse of industrial growth, a panic withdrawal of money from India by foreign institutional investors and a collapse of the rupee to force Pranab Mukherjee to break the code of Omerta and put the blame squarely on the Reserve Bank’s ‘tight monetary policies.’ But when it came to the steps Mukherjee was as much at sea as RBI governor D Subbarao and his advisers. His panacea is to ‘address the imbalance on the fiscal front’, i.e. cut the budget deficit by spending less. The prime minister is obviously of the same opinion. 

Cut expenditures during a recession? Has everyone taken leave of their senses? Have they not seen what the attempt to reduce the budget deficit during a recession has done to Britain and the eurozone? Have our policy makers not noticed the revolt that is taking place against budget cutting throughout western Europe?
 Unlike the US, Japan and Germany where interest rates are already close to zero, the simplest and surest way to revive investment and hire purchase financing in India is to bring down interest rates to where they were  at the beginning of 2010, i.e. by around 3 per cent, and lift the restrictions on lending to the construction industry that have been in place since 2007.  Today, all except the very big borrowers who can negotiate loans at below the prime lending rate, the minimum rate of interest for borrowers is a prohibitive 13 per cent. The maximum rate is admittedly 17 per cent. Borrowers who don’t qualify for loans at even this exorbitant amount simply get denied the credit they need. Only an investor with a penchant for Russian Roulette would borrow at these rates. This is the reason for the 55 per cent postponement of investment intentions reported by the CMIE as long as a year ago, and the 12 per cent drop in production of capital goods and intermediates in January to March 2012.

Raising interest rates

But this is the one measure that the RBI has absolutely refused to consider. Instead, ever since January 2007 with only a brief respite forced upon it by the worldwide recession in 2008-9, the RBI has been relentlessly raising interest rates and curbing money supply ,and thereby choking industrial growth, with the avowed intention of preventing inflation.

Had the Reserve Bank at least admitted its error, and begun cutting its interest rate in October 2011, foreign investors would not have lost faith in the government’s capacity to manage its economy and the rupee would not have lost a quarter of its value in eight months.  But the Reserve Bank and its mentor in the PMO, C Rangarajan, persevered with their tight money policies. When food inflation dropped to nearly zero during the course of 2011 and raw materials prices, other than of oil, slackened because of a slowdown of the Chinese economy, the RBI adroitly switched tracks and began to claim that inflationary ‘potential’ remained so long as the government did not bring down its huge and rising fiscal deficit. That was when India voluntarily joined the collapse that has overcome Britain and the eurozone.

Let us look at what would happen if the RBI did cut interest rates by 3 per cent this month. The immediate effect would be a  rebound of the share market as investors begin to switch money back from banks to the stock market. Foreign investors who are desperately fleeing the euro market, even to debt strapped and politically uncertain America, would immediately sense a profit to be made and come rushing  back into the Indian market. The rise in hire purchase finance and construction ( if physical controls on lending to this sector are lifted)   will trigger increased production of everything from TVs and cars to steel and cement. The IPOs that would follow would attract still more FII. Finally, the rise in production will enlarge the tax base of the economy and the tax revenues of the central and state governments. Then at last will the fiscal to fallow.

But none of this will happen if the RBI does not also openly and candidly admit the mistake it made of trying to fight cost push inflation by killing demand. It is a safe bet that the R$BI will never, never admit that it has made a huge and costly mistake. Will Manmohan Singh government then change its governor, and for good measure his chief economic adviser as well? I wish I could say with any degree of confidence, that he would, but he wouldn’t.

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