For the last several months, the Ministry of Finance and the Reserve Bank of India have been treading different paths. While the former has continued to encourage growth and investment, the latter has been steadily restricting the creation of credit and raising the cost of borrowing to control inflation. In the last one week, the simmering differences between the two have come fully into the open.
In the credit policy announced in December and implemented in January, the RBI raised the cash reserve ratio to 7.5 per cent, taking Rs 14,500 crore out of the market in one swoop, and tightened short-term lending rates to commercial banks. Last week it tweaked ‘provisioning requirements’ and tried to take another Rs 2,000 crore out of the market.
New Delhi’s growing unease over this aggressive anti-inflation drive was reflected in Manmohan Singh’s remark to his Economic Advisory Council on February 3 that “supply constraints” were behind most of the recent rise in prices. His office later took the unusual step of underlining this in a formal note that said: “While global factors and rising demand had contributed to inflation in some sectors, supply constraints had contributed to a larger extent.” Two days later, Finance Minister P Chidambaram instructed the public sector banks not to raise the interest rate on housing loans. Two days after that, the chief economic advisor to the Finance Ministry asserted that the economy was not overheating.
Chidambaram took this uncharacteristic step back towards autarchy because in no other sector of the economy is demand as sensitive to interest rate hikes. Since housing has been one of two main engines of growth in the past four years (the other being consumer durables) a decline in demand for new housing or office space could create an overhang of buildings that are under construction but can no longer find buyers. The resulting property bubble could cause a crash in real estate prices followed by recession.
He acted barely in the nick of time for the very next day ICICI Bank, the second largest in the country, announced increases in interest rates that will add Rs 2,000 a month to the monthly installment payment on a typical Rs 30 lakh 15-year loan. This will not only deter fresh borrowing, but also cause some people, who can no longer meet the monthly payments, to sell their homes.
The ICICI has raised its prime lending rates by no less than 3.75 per cent in the last 13 months. Out of this, 2.25 per cent has come since January. Today, its prime lending rate on loans to corporations has gone up to a forbidding 14.75 per cent, and on home loans to 11.75 per cent. Had Chidambaram not intervened, other banks would have followed suit. Since the rate of inflation measured by the wholesale price index is still only 6.2 per cent, this means that the real rate of interest for corporations would have gone up to over 8 per cent. The last time it rose to this height was in 2000-01. That was also the year in which investment and industrial growth touched its nadir.
RBI Governor YV Reddy is acting in good faith. He does not want to stop growth. But like most modern bankers he believes that governments must give priority to fighting inflation, and that inflation is best fought by monetary instruments, i.e. by the RBI. So deep-rooted is his belief that he embarked on his efforts to, in effect, pre-empt inflation as far back as October 2005.
But his zeal is misplaced. One reason has already been underlined by numerous economists, including the PM. Monetary measures curb demand, but the bulk of the increase in prices over the past year has been caused by shortages in the supply of foodgrains, fruits and vegetables and other primary products.
But there is a second, more important reason. Credit control is an extremely blunt instrument for curbing inflation. Applied too lightly, it barely makes a dent. Applied more heavily it can, and usually does, push the economy into a recession. In the 1930s, and for 40 years thereafter, this was axiomatic. During the worldwide recession of the 1930s, cuts in interest rates proved totally ineffective because, in the face of more than 20 per cent unemployment and huge unused capacities in manufacturing, the desire to invest simply wasn’t there. One by one, the major industrial economies realised they had to stimulate demand directly by creating jobs and augmenting incomes. They did this through deficit-financed public works.
Monetary policy played second fiddle to fiscal pump priming for the next 40 years and only came back into fashion in the early 1980s. The reason was not that Milton Friedman had discovered some profound secret of the economic universe, but simply that in the 1970s, faced with a sharp recession after the first oil price shock, the industrialised economies that tried various forms of pump-priming found that instead of giving them recovery, it was giving them stagflation. Something fundamental had changed.
That change was the onset of globalisation. As the manufacture of consumer goods moved to low wage economies, the high wage countries that tried pump-priming found that they were stimulating imports from Korea, Taiwan or Hong Kong, instead of reviving industry at home. They had to find another way.
The only one that remained was monetary policy, but precisely because monetary policy is far more effective in curbing demand than in stimulating it, the emphasis in the OECD countries shifted from stimulation to prevention. Their goal became to prevent recession by applying monetary brakes to prevent the industrial boom that precedes and leads to it. This is the genesis of the so-called ‘New Economics’ that seeks the Holy Grail of cycle-free growth through the deployment of one, and only one, instrument — control over the supply of money.
The New Economists are aware that the price of clipping off booms is slower growth. But in the industrialised OECD countries where growth has averaged 2 per cent for the last 30 years, and where the rates of net fixed investment are low and sometimes negative, marginally slower growth and some discouragement of investment are not too high a price to pay. But in India, which needs to grow at more than 7 per cent a year to absorb all the new job-seekers and has to do so by creating at least 10 million more jobs in the non-agricultural sector in the next five years, sacrificing growth for stability is simply unthinkable.
Yet, that is precisely where the penchant of Indian policy-makers has led us in the past and is leading us again today. The truth is that economics remains a handmaiden of politics, ever tailoring its so-called laws and prescriptions to political realities. We court disaster when we forget this.
We made this mistake in 1995 and plunged the economy into a seven-year recession. We must not do it again. We should apply brakes on consumption now to prolong the upswing in the economy. But the way to do it is by reducing government spending and bringing down the revenue deficit to zero. With bounding real incomes, buoyant tax revenues and softening global oil prices, this is the moment for eliminating a large part of the remaining government subsidies, notably those on oil products, and reforming the public distribution system to give more effective cover to the poor at lower cost.