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The heat is on

Looking ahead: India should not even flirt with capital account convertibility, writes Prem Shankar Jha.

india Updated: Jun 04, 2007 00:13 IST

So strong is the neo-liberal fever that is coursing through the veins of corporate India that a cautionary word of advice from Prime Minister Manmohan Singh to its CEOs and top managers to moderate their appetite for inordinate salary hikes and inordinate conspicuous consumption, has brought a storm of barely veiled criticism down on his head. But while corporate India wallows in its new-found self-righteousness, the very base of its well-being is being rapidly eroded. It has only a few weeks left to persuade the Manmohan Singh government to ease its curbs on money supply and bring down interest rates. The last opportunity to prevent this will arise when the Reserve Bank of India reviews its credit policy in July. If the Bank does not loosen its hold on money supply, and allow interest rates to start declining once more, then India will slide into a recession by September.

There is still virtually no sign of a recession in the published data. Industrial production continued to rise in March, and manufacturing recorded a 14 per cent increase over last year. There has, as yet, been no actual slackening of investment. And corporate India continues to declare record profits. But these data reflect the boom conditions of the past. The data for industrial production in April, the month in which the RBI yanked interest rates upwards, will only become available in June. Those on investment and profits will take still longer to appear. Even these will not reflect the impact of April’s tightening of credit because there is always a time lag of three to six months, while industry is fulfilling past orders, before the economy feels the full impact of dearer money.

But the first, unmistakable signs of a slackening of economic activity have begun to appear. Real estate prices in the fast-growing suburbs and satellite cities near Mumbai and Delhi, such as Gurgaon and Noida, have come down by 10 to 15 per cent. Home owners who took variable interest loans — about half of the total portfolio — are complaining bitterly because banks have raised their equalised monthly instalments. Banks are reported to be lending less for the purchase of homes. Motorcycle sales, a segment particularly sensitive to the interest rate, fell by a whopping 14 per cent in May. Auto sales have been sustained by the introduction of a spate of new models, but a recent news item in an economic daily asserted that the sale of automobiles had not gone down because buyers had ‘switched to paying cash’. The plain truth is that a large part of economic activity is now driven by consumption demand and not, as was the case even a dozen years ago, by investment. It, therefore, reacts far more rapidly to a change in the cost of money than it used to in the 1980s and early 1990s.

Even fixed investment will soon feel the pinch. Prime lending rates are now running at 12.75 to 13.25 per cent, a full two-and-a-half per cent above where they were a year ago. Long-term interest rates on infrastructure loans have risen by only slightly less. Had inflation continued to rise, it might have prevented the real rate of interest from rising. But in the past two months, the price rise has moderated sharply. The wholesale price index has risen by only 0.4 per cent, i.e., at an annualised rate of 3 per cent. The real rate of interest for good companies is, therefore, at an all-time high of 10 per cent. It had taken only an 8 per cent real rate in 1999 to kill investment stone dead for four years.The high interest rates are also endangering the balance of payments. They have triggered an inflow of foreign exchange on the capital account that has pushed up the value of the rupee to 40 to the dollar. This has caused a flood of non-oil imports (which grew by 54 per cent in May), even as it has begun to hurt exports. Overall, there has been a sharp rise in the vulnerability of the rupee, for a doubling of the trade deficit has been offset by an inflow of highly volatile, essentially speculative, money on the capital account. This was the beginning of the ‘Thai disease’ which brought the east Asian economies down in 1997. It is the last thing India needs.

What made the hike in interest rates in April inexcusable was that it was utterly unnecessary. Inflation, which reached a peak of 6.69 per cent in January, had already fallen below 6 per cent. By May 21, it had come down further to 5.09 per cent. What is more, the causes of this inflation lay outside the control of its bureaucrats, in the vagaries of nature and China’s uncontrollable growth. The entire 0.4 per cent increase since end-March has been caused by a sharp rise in fruit and vegetable prices in April. The core rate of inflation, i.e., the rise in prices of goods not affected by the weather and other exogenous shocks, is running at less than 1 per cent per annum. That means that in the areas of the economy on which the government can exercise control, there is already virtually no inflation.

Since all this could be, and was, foreseen, one is forced to conclude that the RBI has consciously decided to rein in growth in order to achieve some other even more important policy goal. A fortnight ago, the RBI governor told us what it was when he said, on record, that India already had far too high an inflation rate in comparison with South-east and eastern Asia, not to mention the struggling European and North American economies. We had to bring this rate down in line with inflation abroad, he said, in order to further open up the economy. The opening up that he has in mind is to make the rupee convertible on the capital account. You cannot do this if you have a higher than average inflation rate, because you will have to raise interest rates

to bring it down. The higher interest rates will bring foreign exchange pouring in on the capital account. This will increase the supply of money and frustrate the attempt to bring down inflation. This cycle will make the economy more and more unstable, till it collapses.

But as East Asia, Russia, Brazil, Turkey and Argentina have shown, and as Joe Stiglitz has warned, capital account convertibility is a dangerous weapon that cuts both ways. India should not even be flirting with this idea. Instead, it should maintain its exchange controls and give growth priority over price stability. Indeed, in a country as poor as ours, with so much overt or disguised unemployment, to sacrifice growth at the altar of stability is a crime. To say this is not to condemn all stabilisation measures indiscriminately. The RBI did well to start applying a few brakes in October 2005, and to push down a little harder in 2006, for signs of overheating had begun to emerge in a few sectors of the economy and there were makings of a property bubble. But by March, this had already been controlled. The April measures were, therefore, unnecessary. These are the ones that need to be reversed as soon as possible.