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Don’t bank on a bail-out

RBI's method of containing inflation violates a basic theorem of international economics formulated by two economists in the 1950s, writes Prem Shankar Jha.

india Updated: Aug 10, 2007 01:02 IST

There is a spin being given to the latest increase in the cash reserve ratio (CRR) last week. It is that the Reserve Bank had no alternative because the commercial banks were drowning in liquidity following the conversion of billions of dollars on the capital account into rupees. This is utter nonsense. The problem that the RBI sought to ‘solve’ by sucking Rs 16,000 crore out of the banking system was of its own creation, for the money was drawn to India by the sharp increase in interest rates that followed the first and second increases in the CRR in January and April. The third increase in the CRR will only compound the damage that the first two did, for it will firm up the prevailing rates, and keep foreign money flowing into the Indian market. The RBI tacitly conceded this on August 7 when it chopped external commercial borrowing by large Indian corporations to meet their rupee expenditures, off at the knees.

The RBI continues to insist that it pushed up the CRR and interest rates to contain inflation. But its action has violated a basic theorem of international economics formulated by two economists at the IMF in the 1950s. In an open economy, a country’s international account will remain in equilibrium only when three conditions are met: the exchange rate is free to change in response to changes in the demand for and supply of its currency, capital is free to move in and out of the country, and the prevailing interest rate is equal to the prevailing rate of interest in the global financial markets after factoring in the risk of borrowing.

Till July 2006, the government’s management of the economy was in line with this theorem. International equilibrium was maintained through a small but steady depreciation of the rupee in relation to the principal international currencies, that more or less compensated for a slightly higher rate of inflation in India over the global average. In July, the rupee reversed course and began slowly to appreciate. This was partly because of a rise in FDI and inward remittances but mainly because of the depreciation of the dollar. It was, therefore, entirely natural and required no corrective action by the government.

But the two successive increases in the cash reserve ratio destroyed the equilibrium by pushing Indian lending rates well above those in the international financial markets. While the average real lending rate was 4.8 per cent (8.3 per cent nominal minus 3.5 per cent inflation) in the OECD countries earlier this year, and 5.3 per cent in the Gulf Cooperation Council countries, it was 8.6 per cent by the most conservative estimate in India (13 per cent PLR — prime lending rate — minus 4.4 per cent inflation). Since inflation, measured on a month-to-month basis, virtually disappeared after October 2006, the real rate of interest rose close to 11 per cent.

Indian concerns, therefore, decided to go abroad for loans. The figures for external commercial borrowings speak for themselves. In 2005, Indian firms borrowed a billion dollars abroad. In 2006, this figure jumped to $ 13 billion. In January to March this year, it has doubled further to $ 2.1 billion a month. Between April and June it went up further to $ 3.3 billion a month! It was only then, long after the horse had a bolted, that the RBI closed the barn doors.

The bulk of the loans have been taken by a handful of very large companies or groups — Jet Airways, Kingfisher Airlines, Air-India, Indian (Airlines), Tatas, Larsen & Toubro, and a few others. But their borrowing has been dwarfed by that of the two Reliance groups. Between April 2006 and March 2007, the last month for which detailed information on borrowers is available, these raised a total of $ 7.775 billion abroad. This is just under half of all the external commercial borrowing between April 2006 and March 2007. The Reliance groups raised more than a third of this in February and March 2007, after the first increase in the CRR. This surge in private borrowing has combined with NRI deposits seeking windfall gains from the appreciation of the rupee, and short-term foreign investment in the share market, to push up the reserves by $ 49 billion in 15 months. Of this, $ 35 billion flowed in between January and June 2007.

The Reserve Bank violated the basic requirements for economic stability because it sought to bring down inflation the easy way. But as Thailand found out at East Asia’s cost in 1997, this is a road to disaster. The similarities between Thailand in 1996 and early 1997 and India exactly 10 years later are uncanny. The spike in inflation that made the Thai central bank raise interest rates occurred for precisely the same reason as India’s spike in inflation last summer: the effect of a poor monsoon on agriculture. The core rate of inflation in Thailand remained unchanged through the months before the crisis.

In India, inflation (according to the wholesale price index) had increased from 3.5 per cent for the year on April 22, 2006 to 5.7 per cent on October 21. But 3 per cent of this was accounted for by an increase in the prices of primary products during the summer caused by the weather and an increase in international oil prices. The core rate of inflation — i.e. the portion of the rise in prices that monetary policy can curb — was a little under 3 per cent. India, in short, was not suffering from any significant increase in internally generated inflation when RBI Governor Y.V. Reddy brought the hammer down on growth.

In Thailand, the increase in interest rates did not curb investment by very much. All it did was to make investors borrow abroad. Exactly the same thing is happening in India today. The difference, a crucial one, is that the baht was convertible on the capital account, and the Thai government had made a public fetish of maintaining the exchange rate at any cost. Thai borrowers, therefore, faced no limits on their borrowing and took huge, unhedged loans. By contrast, Indian borrowers faced a ceiling of $ 22 billion a year on total borrowing, and had to hedge their loans. However, had the RBI not stopped borrowing to meet rupee expenses this would have only slowed down the build up of debt on the capital account and limit but not eliminate the volatility of capital flows.

In the meantime, India is headed for a recession. Three major banks have already sold Rs 750 crore of bad housing loans, and more are 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. This will cause the demand for cement and steel to slacken.

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.

The BPO industry, which works on a 15 per cent margin, has seen virtually its entire profit wiped out just when a shortage of manpower is forcing it to raise its salaries. Garment exporters are in a panic and beginning to lay off workers because new orders are scant.

Despite all this, Finance Minister P. Chidambaram said in Bangalore this week that a 10 per cent growth this year was, quite literally, unavoidable. He should have remembered that he had made similar predictions in 1996 — but in November that year the rate of industrial growth fell from 13.8 per cent the previous year to 3.5 per cent and stayed below 5 per cent for the next six years.