Time to take charge

Role of govt & RBI

India’s recovery from the steep economic downturn of 2008 has only just begun. No one is quite sure how long it will last and how strong it will be. But speculation is already rife that the Reserve Bank intends to raise the cash reserve ratio by half a per cent.

What is worse, reports of Friday’s meeting between the finance minister and the governor of the Reserve Bank suggest that although both Pranab Mukherjee and Dr Rangarajan, the head of the prime minister’s economic advisory council, have cautioned against any action that breaks the momentum of the recovery that may be setting in, the final say in this will be that of the Reserve Bank.

It is this, more than the impact of a future rise in the CRR that is truly disturbing, for it raises a fundamental political question: just who is governing this country? Who has the final responsibility for taking decisions that will affect the future of millions upon millions of poor Indians who scrape precarious livings day after day in the unorganised sector? Is it the democratically elected government of the country or is it an unelected group of ‘experts’ sitting in the  RBI in Mumbai?

It is obvious from the carefully unsourced leaks given to correspondents that the RBI believes it has the final say, and that Manmohan Singh’s ministers are about  to plead helplessness yet again. The fig leaf that they are likely to trot out for its their surrender is, once again, the 1993 agreement between the ministry of finance and the RBI that in future the former would leave not only the management of the money supply entirely to the latter, ie never again resort to deficit financing, but also the control of inflation.

Since  the RBI can only control inflation by reducing the money supply, this amounts to controlling the rate of growth of investment, GDP and employment. Ever since the 1993 agreement, the RBI has insisted upon the widest possible definition of the latter role and on every occasion, the central government has yielded to it.

The RBI has not yet given any indication yet of what it intends to do, but the global rating agency, Moody’s has nevertheless concluded that it will raise the CRR once again, citing the need to control inflation. The inflation is largely illusory for the wholesale price index has only registered a 0.9 per cent rise in the past year. But there has been a sharp, 8.3 per cent, increase in the prices of primary products because of poor monsoon.

Cost push inflation

And although it is elementary economics that reductions in money supply cannot control a ‘cost push’ inflation caused by physical shortages, this has not deterred the RBI from raising the CRR continuously from January 2007 to August 2008, even though virtually the entire rise in prices during that period was caused by mounting global shortages of food, a global speculative boom in commodity prices, and the diversion of a large part of the American soya and corn crop to the production of ethanol for use as a transport fuel.

Unfortunately, even if the RBI does not raise the CRR this week, there is every possibility that it might do so in January. Some months ago RBI governor Subbarao had said he expected inflationary pressures to re-emerge by the end of the year. And the government’s recent polices have made this almost unavoidable.

The budget for this year contains a record Rs 4,01,000 crore deficit in the current account against a budgeted Rs 1,32,000 crore in the budget for 2008-9. As of now, the entire amount and any supplementary grants that the government may ask for will be raised through borrowings from the commercial banking system. This will, at the very least keep interest rates high and thereby prevent the second, and more important, phase of economic recovery. This is the conversion of a rise in consumption into a rise in investment.

Investment is already lagging far behind. Its most comprehensive measure —the rise in net bank credit in the economy — has been a mere 10.7 per cent in the past year against 22.3 per cent in 2007-08, the last normal year before the global recession. The last few weeks have seen the first stirrings of revival in investment, but a hardening of interest rates in January will almost certainly abort it.
Now that consumer demand is rising briskly, if production capacity does not also increase, there is a real danger of the country running into stagflation next year. One sure way to avoid this is to rely on deficit financing (creating new money) instead of borrowing from the commercial banks, to meet a part of the huge current account deficit this year.

The RBI could easily do this through open market operations, but since it has only held one auction for Rs 6,000 crore so far, there is little prospect of relief from this quarter. Come the year’s end, the government has now to decide whether it or the RBI will decide the fate of the economy.

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