Stop playing to the gallery

May 2014 stares starkly on the political economy horizon; this imperative will be the strict boundary confining current macroeconomic policy options. Within this constraint, the art of the possible has to be explored.

The political economy constraints are that, as in the long-term we are all dead; hence short-termism (August 2013-April 2014), with all its deficiencies, will prevail over structural reforms.

Inflation control gains primacy over all other policy objectives, but there will be obfuscation with emphasis on the Wholesale Price Index (WPI) which shows an inflation of well below 5 per cent.

What affects the masses is retail inflation, and the Consumer Price Index (CPI) inflation shows an increase close to double-digits, which is clearly unacceptable.

Real growth has fallen to 5 per cent and, as part of morale-building, the mainstream thought is that growth in 2013-14 would be on the uptrend, but there is just a possibility that the growth rate could fall below that of last year.

The authorities are in a bind. They would not want to offend large industry, which is pressing for sops, while the threat of capital outflows is resulting in foreign investors being provided concessions and the fisc dare not reduce subsidies.

The authorities have been constrained to calm the nerves of forex market participants by assuring that the balance of payments current account deficit (CAD) would be brought down over the level of 4.8 per cent of GDP in 2012-13.

While the policy is ostensibly to let the market determine the exchange rate, the authorities intervene in the forex market on the pretext that they are controlling ‘volatility’.

Short-term Targets

Effective functioning of policies in 2013-14 would require that each policy instrument be assigned one target.

The objective of monetary policy should be to attain a CPI inflation rate of 5 per cent. Exchange rate policy should be exclusively directed to attaining a CAD of, say, 3-3.5 per cent of GDP.

The Government should work towards attaining maximum growth by easing some of the infrastructural and other constraints without worsening the fiscal situation.

Unfortunately, inverted logic seems to predominate: It is argued that if monetary policy is eased, it will reduce inflation and increase output; an appreciation of the rupee would reduce the CAD; and if only concessions are given to industry and subsidies increased, we would attain higher growth.

These are dangerous ideas, which could worsen the macroeconomic situation.

Since the horizon is only nine months, there is an imperative need for rapid and strong measures, but political economy constraints would rule them out.

Hence, the other option is a series of tiny measures. The measures should be led by monetary policy and exchange rate management, which would then enable the government to facilitate maximising growth. Given the short time available and the need for a number of tiny measures, it will be necessary to take action off policy review dates.

With the change of guard at the RBI, the incoming Governor, Raghuram Rajan, would be expected to greet the financial markets with monetary easing or at least not tightening policy.

Monetary Policy

To ease things, Governor Subbarao would provide signal service to the nation if he were to accept the odium of a couple of rounds of monetary tightening.

Given the present call money rate and the 91 days and 364 days treasury bills rates, the repo rate of 7.25 per cent is totally out of alignment and should be raised.

A cash margin of 25 per cent of the value of imports for three months should be imposed and carved out of the cash credit limits, and import finance should be segregated for a minimum period of three months and subject to an interest rate surcharge of 25 per cent.

If the cash credit facility is provided at, say, 12 per cent, the import finance component would be provided at 15 per cent. This measure would effectively help contain the CAD.

The RBI can face the criticism of industry and other lobbies. The Prime Minister and Finance Minister would recall their own statements of many years ago. The PM said: “there is no better anti-poverty programme than the control of inflation”.

The FM has similarly said: “inflation control is the Dharma of the RBI”. Once the PM and FM are supportive of the RBI, overt criticism by government officials would stop and the RBI would be able to handle the onslaught of industry and others.

Reduction of CAD

As part of its declared policy of controlling ‘volatility’, and not the exchange rate, the RBI should strictly ensure that any spot sales are simultaneously matched with forward purchases. As such, the market would determine the exchange rate and the RBI would only alter the inter-temporal movements to reduce volatility.

With the increased GDP base during the past two decades, the government should accept a growth rate of 6 per cent as the secular rate of growth.

Without widening the fiscal deficit, the government could shuffle the revenue-expenditure mix to provide effective support to foster growth. From the short-term horizon, structural reforms are not relevant even though they are vital for secular growth.

In the absence of strong and effective short-term measures, we should be prepared for a full blown crisis by the middle of 2014.

(The author is an economist.)

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