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The global financial meltdown is unprecedented and the contagion has spread like wild fire. The central issue we need to address is whether the Indian monetary policy response was appropriate. The major industrial countries have worked in concert and pumped in large liquidity into the system and we, in India, have done likewise. What was ostensibly a liquidity problem is turning into a solvency problem.

We need to look at the path-breaking work, in 1926, by a Russian economist, Nickolai Kondratieff entitled Long Waves in Economic Life. The major premise was that capitalist economies experience long wave cycles of boom and bust and that each cycle lasts 50-60 years.

This work was unfortunately considered as a veiled attack on Stalin’s total collectivisation of agriculture and, in 1938, he was given the death penalty. Today’s economists and policymakers would do well to carefully imbibe Kondratieff’s fundamental work.

According to Kondratieff, there are four phases of the long wave cycle: Inflationary growth, stagflation/recession, deflationary growth or a plateau and, finally, depression. Furthermore, Kondratieff held the view that in each phase of the cycle, policy reactions are tempered by knowledge and experience and the endeavour is to attain a higher peak.

Policymakers and opinion makers, the world over, would make us believe that all this is history and that we now have sound systems in place to ward off a long depression. The problems which have become visible may be only the tip of the iceberg and the world economy could well be headed to a depression.

In India, we are being assured that as we do not have the complex financial products, which have been the bane of industrial countries, we are protected from the international turmoil. Our systems could be as strong as or as fragile as global systems and, hence, there is no room for complacency. Furthermore, we could be at a different inflexion point of the cycle that could be deceptive. Still, the Indian situation is of relatively high growth of around 7.5 per cent in 2008-09 and 6-6.5 per cent in 2009-10. What is worrisome is that while, in recent weeks, inflation has somewhat abated, it is intolerable as it is still in double-digits. In such a situation, a large and sudden injection of liquidity is a cause of anxiety.

To be effective, monetary policy has to recognise the inevitability of real sector cycles. During the boom, there is a general euphoria and the central bank is egged on to lower interest rates and to flood the system with created money. As the party gets uncontrollably merry, the central bank has to take away the punch bowl but, by then, the downturn of the cycle would have started. The art of good monetary management is to undertake monetary tightening during the upturn of the cycle, well before the upper turning point is reached.

This is precisely what the former RBI Governor, Dr Y. V. Reddy, tried to do all along since 2004. Admittedly, monetary policy cannot be formulated in a vacuum but has to be consistent with the overall direction of economic policy. Dr Reddy’s parting remarks were telling when he said that had he had his way he would have tightened further. Dr Reddy was pilloried and burnt at the stakes but the merits of his monetary policy are slowly being recognised. His “Beatification” and subsequent “Canonisation” would take place only after the definitive history of the recent period is written.

In the major industrial countries and in a number of emerging market economies, large liquidity has been pumped in. Likewise, in India, the Reserve Bank of India (RBI) has recently pumped in at least Rs 300,000 crore, approximately equivalent to 7.5 per cent of banks’ deposit liabilities.

The repo rate has been reduced from 9 per cent to 7.5 per cent. The old central banking dictum on interest rates was “up by ones” and “down by halves” but the recent Indian experience appears to be “up by quarters” and “down by ones”.

Apart from a liquidity shortage, resulting in a cessation of credit, the situation in India has been one of over-extension of credit relative to the resources of the banking system. The year-on-year incremental credit-deposit ratio is a staggering 96 per cent. No wonder the banks have no resources to lend. After three years of unbridled 30 per cent per annum credit expansion, there is bound to be a slowdown.

The problem in India regarding credit expansion is structural and not shortage of liquidity. The former RBI Governor, late Dr I. G. Patel, would often tell the banks “do not lend the money you do not have.”

Rather than suddenly pumping in over Rs 300,000 crore of liquidity into the system within a few weeks, it would have been preferable to calibrate the release. Furthermore, the sharp reduction in the repo rate has made it even more out of kilter with other rates in the system. To be effective, the RBI’s policy signalling rate should be a penal rate and not a subvention.

The history of foreign institutional investments the world over is that large inflows are followed by outflows and, as such, the fall in the forex reserves was predictable. Admittedly, when forex reserves fall precipitously, the RBI should step in and prevent a total dislocation in the credit system by releasing some domestic liquidity.

Illustratively, if Rs 100 is withdrawn as a result of a forex reserve loss, the RBI should restore, say, only Rs 75. Excessive replacement of the reduction in liquidity will only reinforce the subsequent forex reserve loss.

Over time, the RBI’s exchange rate management has been par excellence. One should not look at nominal exchange rates in relation to the US dollar but monitor the Real Effective Exchange Rate (REER). In the recent period, the RBI has allowed only a gentle depreciation of the REER, which is only appropriate. Rather than opening up external commercial borrowings, the authorities should have considered:

Increasing the ceiling on FII investment in the government securities market; and

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