How to fix this mess

P Chidambaram is doing the opposite of what textbooks recommend. When inflationary clouds collected on the horizon, he decided to seed the air with money. When a credit drought struck, he began hoarding liquidity, writes Pramit Pal Chaudhuri.

There is plenty of brawn in the Indian economy, but its financial brain is in danger of slipping into a coma. New Delhi is loudly blaming the Wall Street plague. However, there is a good case for saying the government’s actions are adding to the epidemic. While Finance Minister P Chidambaram talks smoothly, his policy is full of rocks.

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Rewind to earlier this year when double-digit inflation ravaged the country. The primary reason for that was the huge wave of foreign capital that entered the Indian economy from mid-2008. So much money sloshing around helped drive up prices. The government aggravated things by tossing more money into the pyre, spending more on pretty much everything.

The then Reserve Bank of India governor, YV Reddy, warned in June that a deficit-ridden unidirectional fiscal policy would make it difficult to fashion an anti-inflationary monetary policy. A former advisor in the Prime Minister’s Office admitted Reddy had been warning New Delhi for two years that Chidambaram’s fiscal exuberance was going to be reflected in rising prices. The governor tried to steady the boat by hiking interest rates, increasing the cash reserve ratio (CRR) of banks and issuing market stabilisation scheme (MSS) bonds to absorb the dollar inflow. He was partially successful, but he did leave the financial system with a huge kitty: Rs 1.73 trillion of MSS bonds and Rs 3 trillion in the crr.

Chidambaram spent as fast as Reddy saved. Reserve money up to the summer of this year was growing at three times the rate it did last year. The culprit for this inflationary development: government withdrawals from the RBI were nearly six times higher than the previous year. The fiscal deficit of India, including off-budget items, is a red ocean. It is possible that as much a quarter of the inflation Indians are suffering to this day can be traced back to a finance ministry running amok.

The sub-prime crisis in the US was pooh-poohed by New Delhi as a faraway problem in a faraway land. Though real estate and infotech took a few blows, this should have been largely true. The most overt impact of the West’s woes was for foreign financial institutional investors to set sail for home. But they have pulled out over $10 billion this year, hardly enough to rock a trillion-dollar economy. Yet this triggered a credit crunch in India, putting the squeeze on banking, mutual funds, the private sector and even the rupee.

The reason India is a nation searching for liquidity today is almost solely the finance ministry. Sublimely complacent about sub-prime, Chidambaram and the new RBI governor, D. Subbarao, focused on extracting money out of the system. In September and the first week of October, this duo sucked a trillion rupees out of the system. Another stratagem has been to declare lots of expenditure like farm loan waivers, oil and fertiliser subsidies; force the banking sector to pay for these subsidies and then dawdle over issuing the government compensation. These now total well over a trillion rupees — all that much less capital for banks to lend to anyone else.

If there is liquidity problem in India today it is largely self-inflicted. The rupees that the diuretic duo of Chidambaram and Subbarao has released into the system, is dwarfed by the rupees they took out earlier or are hoarding. Presumably, there is logic behind all this, but right now only theories abound.

One theory is that they are still inflation obsessed. It’s still double-digit. And while the wholesale price index is declining, the rural consumer price index rose one point in August. With assembly elections around the corner and a general election around the block, the UPA is in a frenzy about prices.

Economic policies can take months to bear fruit. What is clear is that sinking global prices will temper inflation over the coming months. As the Finance Ministry’s economic advisor Arvind Virmani has noted, the three main sources of rising prices — edible oil, petroleum products, and iron and steel — are all southbound. Even Chidambaram seems to realise inflation is yesterday’s problem and has said, “The root cause of the present uncertainty is liquidity.”

Another theory is that they want to avoid a run on the rupee. The rupee’s 16 per cent fall this year is the worst tumble since 1991. The RBI is intervening to keep it from piercing the 50-to-a-dollar barrier. At a time when Indian exporters of both goods and services locked themselves into forward dollar trades that assumed the rupee would rise, a rupee in free fall would wreak havoc across the market. It would also cause a trade deficit detonation as oil imports became costlier.

Yet, the rising dollar reflects a shortage of dollars in the system and India happens to be sitting on a record foreign exchange reserve buffer. It exists for such times, but needs to be used credibly.

Finally, there is a view that Chidambaram wants to make the government’s books look better than they are when Parliament meets this week-end. Hence his delayed subsidy compensation. And hence his aggressive collection of advance taxes even though this makes credit scarcer. Note that when Virmani was asked what he thought was the biggest threat to the economy, he said, “I am unable to discuss” because it has to be put in Parliament — the fiscal situation. Brace for bad numbers. Once all accounts are squared, the fiscal deficit may be heading for 10 per cent of GDP.

The finance minister’s pattern seems to be to do the opposite of what the textbooks recommend. When inflationary clouds collected on the horizon, he decided to seed the air with money. When a credit drought struck, he began hoarding liquidity. In between, he has ensured the government’s coffers are filled with debt. As one senior representative of India Inc commented, “Chidambaram is okay in a status quo situation. In a crisis he doesn’t have what it takes.”