The Hindu Business Line : When text-book rules fail

In less than two weeks the RBI will announce its new monetary policy. The temptation to raise interest rates or keep them at current levels must be resisted.
ASHOAK UPADHYAY suggests why.

In a message to both the International Monetary Fund and his constituency back home, the Finance Minister, Mr P. Chidambaram, warned of stern fiscal steps to control inflation even if they involved some sacrifice of revenues “badly needed for social sector spending”.

Speaking to the Press Trust of India in Washington, where the Finance Minister of the world’s second fastest growing economy is attending the spring meeting of the World Bank and IMF, Mr. Chidambaram gave the impression of waging a strategic battle against inflation that has, by current account, reached a 40-month high. At 7.41 per cent, the Wholesale Price Index is far above the RBI’s tolerance level and it has got the UPA government worried enough to do what it should have done long before to keep prices from breaching the five per cent mark.

That reductions in Customs duties were necessary was fairly evident when global grain prices began to harden and the nation was importing inflation with wheat. Belated as the step was, reduction in Customs duties on edible oils and other essentials did have a salutary effect even if was temporary.

That immediate impact of policy may perhaps have encouraged Mr Chidambaram to threaten further duty cuts, and interdictions on exports to rein in prices, even if the export bans and import duty reductions entail revenue losses.

Considering the IMF has just released its own take on Asian inflation that it warns could affect growth across the region, Mr Chidambaram was quick to assert just how alert his government is to the dangers the unprecedented price rise poses, especially in the last year of its term and before general elections next year.

With the Opposition girding for protests in the summer, and Assembly elections due some months hence in the crucial State of Karnataka, the UPA does not want to let the BJP tarnish its image as the author of one of the best growth stories in post-Independent India, a growth free of inflation and laced with yearly increases in social sector spending.

Inflation at current levels will remind the Government of its own attitude to its inheritance in 2004. When Mr Chidambaram presented his first full Budget in 2005, he had to admit growth in 2003-04 was indeed “broad-based” on the back of a poor 4 per cent the previous year.

He qualified that recognition with a laundry list of woes: inflation of 8.7 per cent, poor business confidence, liquidity overhang and a deficient monsoon.

Uncannily, the Opposition could just as well hurl the same list back at the UPA; rising inflation on the back of global oil prices but stoked primarily by rising domestic food prices, a dipping business confidence that has been noted by the RBI and liquidity fluctuations occasioned by an overly cautious and costly foreign exchange management.

Growth forecasts are slipping, the latest being the IMF’s warning of lower than 8 per cent growth for the current year.

End of a cycle or of policy change?

It might be tempting to consider the negative features of the economy as symptoms of a cyclical downturn; after four years of rapid growth, something has to give; the dream cannot last forever.

The counter argument would run thus: if the dream run was the result of a series of policy changes that came into play from 2003-04 and exhausted itself in 2008, surely another round of policy intervention would work similar results, even if after a while?

If policy can work to control the destructive elements in the economy, cannot policies work just as well to encourage its positive tendencies? What should be the response of monetary authorities to a paradox of slipping growth and rising inflation? When Mr Chidambaram spoke of the readiness of the Reserve Bank of India to use monetary measures to curb inflation, was he signalling an interest rate hike — the normal response of a central bank to dampen overheating prices?

It almost seems natural to expect the central bank to raise some rate or other in its quest for price stability. That intervention worked well over the last two years when successive interest rates or short-term interest rate hikes served to choke off incipient overheating.

Evidence points to its having worked too well. Credit offtake has fallen from the high of 30 per cent to around 24 per cent, and falling. The RBI ‘s own data record slippages in consumption demand, a fall that has led to lower orders and sales for firms across the spectrum, resulting in lower industrial output. After a brief lull, inflation is once again on the rise to just a shade below 2004 levels.

Demand-pulled or supply-pushed?

It is by now fairly clear that this second round of inflation is not the outcome of exuberant demand. That liquidity levels, measured by money supply are still above the tolerance level of 17 per cent has less to do with excess demand than with a forex reserves management whose undue emphasis on exchange rate stability — read as weak rupee — has landed the central bank with the unpleasant task of skimming off excess dollars in costly sterilising campaigns.

The MSS scheme is costing the government dear and so far New Delhi has been able to keep those burgeoning costs off its Budget that looks squeaky clean at the moment. But someone has to pay to keep the rupee artificially low, and no prizes for guessing who that might be.

With global inflation showing little easing, a weak rupee forces the nation to import more than just food. With the RBI maintaining short-term interest rates at current levels that are far higher than the US short-term rates for instance, domestic bonds and securities appear attractive. Not surprisingly, FIIs in February were urging SEBI to up individual limits in government paper.

With bond yields peaking at 8 per cent in March and low borrowing costs in overseas markets, domestic gilt markets are the flavour of the season. The RBI inadvertently helps keep bond supplies at high levels through its absorption of surplus cash that could add to inflation.

Interest rates cut

Cutting interest rates would help the RBI achieve two objectives; in part the inflows might just drop to more manageable levels as the interest rate differential narrows. But more importantly, the central bank would send out the signal that it is aligned to growth and that pulling it up by its bootstraps to former levels is the best antidote to inflation.

With falling output and consumer demand, low incomes in the vast hinterland of the organised economy and inflation that hurts the les privileged, the RBI can hardly expect hardened interest rates to manage price stability. India defies textbook theories, and the current scenario more than anything else demands a bit of risk taking.

Mr Chidambaram can do worse than use fiscal measures to rein in prices of supply-constrained goods. The current inflation calls for systemic policy measures, not monetary measures.

In less than two weeks, the RBI will announce its annual monetary policy. The temptation to play its part in the war on inflation will be strong. But it must resist because any hardening of even the repo rates may work to skim off excess liquidity but it will work even more lethally to choke growth. And it will not bring down food prices.

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