The Hindu Business Line : Economy must decouple from financial markets

Anxiety, bordering on panic, is setting in among policymakers. Import duties have been cut and the Finance Minister has spoken of a tough interest rate response. He is willing to sacrifice growth to control inflation.

Is it then the diagnosis of government and the RBI that interest rates are too low and investment and consumer spending must be slowed down, i.e., aggregate demand in the economy should be curbed?

The remedy for rising prices, in this view, lies in aggressive monetary tightening.

As always in our country, the most absurd contradictions abound. Just days before, the Pay Commission announced sharp salary hikes for employees of the Union Government.

It won’t be long before State Governments follow suit, injecting tens of thousands of crores of new purchasing power into the economy. So much for a consistent policy framework to tackle inflation.

Confusing signals

The signals from the economy are confusing. On the one hand, in 2007-08, bank credit did not grow as much as in the previous year (which, admittedly, was exceptionally good).

Also, industrial production and infrastructure performance have fallen off in recent months. But, surprisingly, direct tax collections have soared, emboldening the Finance Minister to target revenue of Rs 1,000 crore a day in the current financial year.

If the economy is really slowing (or will be slowed by policy measures), this goal is unlikely to be achieved.

Therefore, given that government’s cost structure is to a significant degree fixed (salaries, interest, subsidies, etc.), higher market borrowings could be in store. Seen together with the prospective monetary tightening (CRR hikes, rise in the RBI’s benchmark rates) to check inflation, the outlook for liquidity and interest rates is none too good.

The key question is what is the ideal combination of growth and inflation – 8% and 5%?, 7% and 4%?, 5% and 3%? Clearly, most would balk at the growth rate being practically cut to half as too high a price to pay to rein in inflation.

Asset prices

Another factor to be reckoned is the contribution of booming asset (stocks, property) prices in the last few years. This stimulant could be absent (or not operate with the same strength) and is certain to cause a noticeable impact on the economy.

The lesson clearly is that there is no substitute for endogenously-driven growth. Much-needed domestic investment in agriculture and urban, rural and social infrastructure cannot be allowed to be scuppered by financial crises in far-off lands.

We must become resilient to global financial shocks, even while fully exploiting the benefits of globalisation of trade in goods and services and insulating the economy from the effects of financial excesses.

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