Moment of truth

It is only the RBI’s frequent references to “inflationary expectations” that reveal the source of its anxiety.

The powerful endorsement by Sonia Gandhi of the government’s programme to reduce  its soaring budget deficit  by drastically cutting back  subsidies, has ended a three year stand-off over economic policy  between the parliamentary and  organizational wings of the Congress that has  paralyzed the government, and abruptly ended  India’s eight year run of growth and given no end of not-so-secret pleasure to it’s detractors abroad.

Although nearly all the decisions that led to an increase in the estimated fiscal deficit from Rs 1.32 lakh crore to Rs 5 lakh crore in a mere three years were foisted on the government by the party organization, it was Dr. Singh who had to bear the blame for the consequences.  From being universally acclaimed as the architect of India’s swift and painless transition from being one of the slowest growing economies in the world into the second fastest, he is being held responsible today for undoing everything he made possible a decade and a half ago.

India’s recent economic decline has been staggering. For eight years, till 2010-11, its economy grew by an average  of 8.5 per cent a year. Last year its growth slipped to 6.5 per cent; Industrial production crashed from 8.2 per cent to 2.8 per cent; and Investment, measured from mid-2011 to mid-2012, fell by more than 52 percent in real terms, perhaps the greatest single year fall in recorded history. From March to August this year industrial production has contracted by 0.1 per cent, and manufacturing by 0.5 per cent.  It is no surprise that growth is slated to fall further to a second 4.9 percent this year. Excluding the transition years of 1991-93, this will be the lowest rate of growth India will have recorded in forty years.

This cause of this decline is not global recession, which did not prevent India’s exports by growing by 36 per cent in 2011-12. Nor is it India’s infrastructural weakness, proliferating red tape, and growing averseness to risk of its besieged bureaucracy, as has been argued by some commentators in recent weeks. These can choke growth but not make already established units  cut back production and shelve growth and expansion plans.
Its sole cause can be traced back to one single policy decision that was taken by the Reserve Bank of India—  to give priority to containing inflation, over promoting growth.
The relentless increase of interest rates that has followed has put drastic curbs on
investment, brought investment in the infrastructure close to a complete halt, and choked industrial growth literally to death. But it has had no perceptible impact upon  the rise in prices.

Industrial decline

The Bank started down this road not in March 2010, as most analysts believe, but under Dr Subba Rao’s predecessor, Dr Y.V Reddy, in January 2007, at a time when the cost of living index had only ticked upwards by 2 per cent to 6.7 per cent. One result of this was that India was already in an industrial decline in August 2008, when the global recession gave the government a reason to force a still-reluctant Reddy to lower interest rates and ease the supply of money to prevent it from spreading into India.

Easier credit and a huge fiscal stimulus programme succeeded in doing this, but the Bank had only retreated, not relented. After only 15 months of easy money policies, it began to raise interest rates once again in March 2010. Its excuse in this second round of increases was the same as in the first:  as in 2007, was a sharp resurgence of inflation which touched ten percent in February.

The Bank’s ostensible reason for embarking upon a policy that could not fail to choke growth and throw millions out of work have never been entirely convincing.  From its first interest rate hike in 2007 till its most recent refusal to lower policy rates last week, it has cited the need to control inflation, and refused to acknowledge something that second year students of economics should know that monetary policy can only inflation caused by an excess of demand and can do nothing to curb one that is caused by shortages of supply, whether of food, raw materials or labour. This elementary mistake has tied its explanations for  not lowering policy interest rates up in knots.

Thus in its latest annual report, released only weeks before the government embarked upon its fiscal reform policy in September, it simultaneously asserted that the pressure of demand remained high in several sectors of the economy, and that private savings in financial assets had fallen by 36 per cent in the previous two years (from 12.2 to 7.8 per cent of GDP), because people were drawing down their savings in order to maintain their living standards, or survive after losing their jobs. By the same token it did not even try to explain how there could be an excess of demand over supply when investment had halved and sales of manufactured goods were declining.

It is only the RBI’s frequent references to “inflationary expectations” that reveal the source of its anxiety. This is the UPA’s cavalier disregard for the deficit reduction targets set in the Fiscal Responsibility and Budgetary Management Act as it embarked upon a spending spree to ensure ‘socially inclusive’ development. This, it feared, would create a ‘fiscal overhang’ that would come crashing down on the economy the moment consumers’ confidence in their future revived and they bgan to spend again. So to avert a possible inflationary spiral tomorrow the RBI decided to choke off investment and consumer demand today.

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