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Tuesday, Feb 05, 2002

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RBI Report on Currency and Finance, 2000-01 -- Policy-makers vs econometricians

N. A. Mujumdar

THE DECELERATION of the economic growth seems to be persisting. GDP growth rate declined from 6.6 per cent in 1998-99 to 6.4 per cent in 1999-2000, and further down to 5.2 per cent in 2000-01. The growth rate during the first half of 2001-02 at 5.3 per cent is distinctly lower than the 6.2 per cent recorded during the corresponding previous period.

The Reserve Bank of India's team of experts deserves to be commended for addressing this issue of slowdown, now a global phenomenon. `Revitalising Growth' is the theme of the RBI's Report on Currency and Finance for 2000-01. Does it provide any ready-made policy inputs? It is legitimate to ask this question because the RBI Deputy Governor, Dr Y. V. Reddy, makes the following statement in his Foreword: "As in the past, the approach is one of policy-oriented research and empirical verification so that public opinion is suitably empowered with information and specialised assessment." In fact, the Report exposes the great divide between the policy-maker, whose feet are firmly on the ground and the econometrician who lives in a world of abstract models.

The econometrician is known to be "massaging" the data, cleaning them of peaks and troughs, so that he reaches the conclusions he set out to reach in the beginning. The divide is, perhaps, all to the good otherwise, if the policy-maker accepts all the recommendations of the econometrician as gospel truth, there is the danger of the economy running into rough weather!

One may begin with the interesting insights provided by the penetrating analysis of the Report. An important finding is that the current phase of slow down represents "a loss of spread rather than a halt in growth. Cyclical patterns in activity are detected but these are of limited duration and impact. The Indian economy is characterised by stable and converging cycles which could be modulated with counter cyclical policies. The impulses for growth can be generated and nurtured primarily by releasing the structural constraints which can shift the potential growth frontiers upwards" (page III-S-1).

The RBI experts have avoided the temptation to explain the slowdown in terms of business cycles, as in the case of some developed economies. It must be added that the slowdown is a deceleration in growth and not a slump. Even the pessimistic forecast of growth for 2001-02 places the growth rate at around 5 per cent — way above the so-called Hindu rate of growth. `Revitalising Growth', as Dr Reddy puts it, is, perhaps, a more appropriate description of the theme. If the target 8 per cent growth is to be sustained in the Tenth Year Plan (2002-07), as envisaged by the Draft Approach Paper, how does one go about it? It is here that the "spread of growth" concept assumes significance. Spread could be sectoral or regional. If GDP is to grow at 8 per cent, the agricultural sector has to grow at some 4 per cent. This is a tautology but policy-makers ignored this aspect in the 1990s when the average annual growth of agriculture decelerated from 5.2 per cent in the 1980s to 2.6 per cent. The flow of credit to agriculture shrank and so on.

Again, the banking sector was caught napping when the new revolution in the information technology took place. Only in the late 1990s did the RBI and banks wake up to assist the IT sector. In terms of regional spread, some regions have the potential to grow faster than others, given the injection of the some quantum of capital. The Report has placed firmly on the development agenda the requirement that all policies, including monetary and credit policies, should focus on the "spread" aspect of growth.

Equally interesting is the insight provided by the Report on the capital market, which comes as a refreshing change from the obsessive preoccupation of the present-day policy-makers with the development of the capital market. The report poses the question: "Which system — capital market-based or financial intermediation — is more efficient in the long run in allocating financial resources?" (page VIII-13)

The two competing systems appear to be converging in recent years. In Japan and Germany — economies where banks play a crucial role — capital markets are becoming increasingly important. On the other hand, in the US banks are increasingly required to play a greater role in corporate finance. The Report, therefore, recommends a suitable mix of the two: "Thus, the co-existence of both the systems is socially desirable not only because it encourages competition but also because it reduces transaction costs within the financial system and helps improve resource allocation within the economy" (page VII -14). India's policy-makers would do well to heed this advice because, with so many artificial props given to boost the capital market and the discrimination against commercial and development banks, the capital market has failed to develop.

Among the disturbing recommendations of the report, the two relating to inflation and savings need to be highlighted. During this financial year so far, inflation declined sharply to 1.32 per cent (week ended January 19). Then, is this deflation responsible for the slowdown? The Report asserts that it is so. Threshold inflation — that is, growth maximising inflation rate — is estimated at 5 per cent. There are potential output losses involved in further disinflation. Sacrifice ratio estimates suggest that in a low inflation environment, a one percentage point reduction in inflation leads to a decline in output by 2 percentage points below the potential" (pageV-26).This assertion is repeated elsewhere in the Report also. This recommendation is bound to shock many balanced policy-makers. Conventional wisdom based on cross-country empirical experience has always maintained that a moderate inflation is good for a developing economy. The objective, therefore, should be to aim at not zero inflation but, say, 1 or 2 per cent inflation. Beyond that level, inflation creates distortions in income distribution and affects employment adversely. Similarly, in the 1970s, there were years when the inflation was moderate, say, below 2 per cent and yet, growth was not sacrificed. In any case, this conclusion of the report needs a second look. Is infirmity or massaging of data responsible for the emergence of such an unrealistic conclusion?

The Report's profound observations on savings are equally perplexing to conventional analysts. "Other things remaining the same, a one per cent increase each in income and intermediation ratio (secondary issues to primary issues ratio, as used in flow of funds accounts), would increase the aggregate saving rate by 6.6 percentage points and 3.4 percentage points, respectively. The interest rate, that is, real deposit rate has a lesser but positive impact on gross savings rate, implying that as much as 12 per cent points change in the real interest rate is required to increase aggregate savings by one percentage point. The results indicate that the dynamic response of the private saving rate to per capita income (per capita disposable income in the relevant scale variable in studying private saving behaviour) works out to 7.8" (page III-7).

An increase of 12 per cent in real interest rate to achieve a one per cent rise in aggregate saving rate? Bewildering. Are household sectors's financial savings, that account for the bulk of aggregrate financial savings in the economy, interest-sensitive? Or is there a threshold beyond which they become interest-sensitive? These questions are critical in the Indian context because historically, banks have attracted deposits of the household sector, not withstanding infirmities such as relatively lower interest rates, and taxability of interest income, and tax deduction at source. In any case, to those familiar with the saving behaviour of the household sector, a 12 per cent real increase looks astronomical. Similarly, what is the economic meaning of the intermediation ratio in the Indian capital market? These issues need to be thoroughly re-examined before arriving at such a startling conclusion.

The report is euphoric that capital flows have begun to play a significant role in India's growth dynamics. Evidence of strong complementarity with domestic investment suggests that capital flows brighten the overall investment climate and stimulate domestic investment even when a part of the capital flows actually gets absorbed in the form of accretion to reserves (Page VI-20). What about the utilisation of reserves? The report is silent on this aspect, perhaps, because the model does not capture this dimension. If we spend $7 billion annually on the import of gold, how does accretion of reserves help growth? Gold imports neither enhance productive capacity of the economy nor its export capability. But this aspect of appropriate utilisation of reserves interests model builders.

Then there are more mundane issues. The report refers to the huge foodgrains stocks with the public sector, aggregating to 59.1 million tonnes at the end of November 2001. That there is enormous scope for undertaking watershed development programmes is too well-known. How about using a part of these surplus foodgrains to facilitate the undertaking of such programmes on a massive scale?

This would go some way towards revitalising growth, in terms of more employment, higher rural incomes, food security and reduction of poverty. But such mundane matters, perhaps, cannot be captured by elegant econometric models.

On the whole, the policy-maker is bound to benefit by the interesting insights provided by the report into the functioning of the economy. At the same time, there is some merit in the Indian policy-maker maintaining some distance from the econometrician. Policy-making remains an art, it cannot be replaced by software.

(The author is a former principal advisor to the RBI.)

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