Any attempt to revive growth through interest rate cuts will simply return the organised economy to highly inflationary, speculation-driven economic expansion.

As the Reserve Bank of India runs up to its mid-quarter review of monetary policy next month, what options will it consider for an economy that is clearly stalling?

One of the more apparent problems is a liquidity deficit that has persisted since November last. The government's market borrowings programme has outstripped the RBI's infusion following January's cut in CRR; with tax payments due in March, banks may run short of money. But for what? Certainly not to lend at the rate they have been lending till the last quarter of 2010-11. Perhaps they will need that extra liquidity to cover their flanks as the spectre of bad loans gets bigger. How long can banks keep rescheduling sick loans before they are transferred to the log books of Non-performing Assets?

The State Bank of India, the bellwether for most of the scheduled banks, recently sounded the alarm bells, muted no doubt by the sweet chimes of profit spikes, when it reported a huge jump in its NPAs in the last quarter.

This may surprise the RBI that has already acknowledged this trend, sourcing it to priority sector lending, primarily. With refreshing candour, the SBI chairman admitted an airline company accounted for a fourth of Rs 6,000 crore of fresh NPAs in the third quarter. Mr Pratip Chaudhuri was quick to remind the media that the worst was over since the “NPA storm had subsided”. But has it? And is so, how?

Most analysts would not be surprised if the coming quarters were to see an NPA pile-up: rollovers have limited durations, and if the economy continues to remain in its current state of suspended confidence, more existing loans will turn sick. Banks may ward off potentially bad assets by not lending, or doing so with caution; the RBI's third quarter review suggests that that attitude may have already set in, as it notes a decline in credit growth. But that solution is double-edged and may ricochet by deepening the current depressed state of demand and thus contaminating more extant loans.

Whistling in the dark

So the SBI chairman is whistling in the dark just as are policymakers in New Delhi who believe that December's depressed output numbers can be handled by the simple expedient of interest rate reductions. The buck may have already been passed to Mint Road and the call for more action than cuts in CRR may reverberate increasingly in the coming days.

But the RBI has probably pre-empted that sentiment. In its third quarter review it still moans the stickiness of inflation to justify its current rate policy. But its analysis of macroeconomic trends does more than just implicitly defend the status quo on interest rates. It points to complications such as falling investment demand in an environment of high inflation and currency pressures and, slowing growth

Assuming the RBI bows to popular belief in the power of rate reductions to work a recovery, could one expect consumers to return to, say, the consumer durables market, to housing? Could the “slack in investment” pick up, thus returning some robustness to aggregate demand that would lead to economic recovery enough to warrant confidence in GDP growth of more than 7 per cent? Probably yes. But that growth would be inflation-ridden, thus adding to existing high prices. Why? Because of the kind of investment that is likely to pick up the “slack.”

Evidence does point to the fact that real-estate, within the broader rubric of ‘Services', has been the main driver of investment growth.

Third quarter review data on GDP sector-wise expansion reveal just how important Services have been and within that, construction, financial and insurance services and real-estate. In first half of 2011-12, the growth rate in industry and manufacturing, not to mention mining and other core sectors, decelerated by more than half from the levels of 2009-10; not so “Trade, Hotels, Transport, Storage and Communication” and “Financing, Insurance, Business Services Real Estate.” Both have increased some notches over 2009-10 in the first half 2011-12. At 11.3 per cent and 9.8 per cent, they hold up the GDP for the year from falling far too much below 7 per cent.

A growth pattern based on Services (with ITES exports in the doldrums) is inherently inflationary and the RBI, one imagines, recognisedit as such when it began its rate hikes. The organised economy has almost all through its growth phase since the first UPA term relied almost exclusively for its momentum on Services; to start with ITES industries that created the purchasing power and then ancillary services such as transport trade, hotels and most importantly, real-estate. Manufacturing has usually been the mid-stream beneficiary of an inflationary tide that returned it “pricing power.”

These “interest-sensitive” Services sectors, not to mention feeder industries such as cement and steel, responded to the RBI's rate signals enough to stave off an overheating. In effect, the freshly shaved GDP forecast of less than even 7 per cent (6.9 per cent!) probably represents the true potential of the economy than that over-inflated growth of 8-9 per cent, which hurts the majority of Indians.

The growth trap

This means that any attempt to revive growth through interest rate cuts will simply return the organised economy (and its country cousins) to highly inflationary, speculation-driven economic expansion: inevitably, the RBI will be forced to tighten monetary policy, thus describing a circular trajectory for itself and the economy.

In order to escape this inflationary trap, policymakers have to recognise what is “hidden in plain sight”; issues that have dogged and kept away investments to enhance capacity in the real economy, from roads to healthcare facilities. A less transaction-cost driven framework, clear guidelines about investments and a focus on the core sector that gets away from an accountant's anxiety about fund raising to committed project governance. These would, in the long run, push back the boundaries of current economic potential.

(This article was published on February 14, 2012)
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