The investment slowdown-led growth deceleration in the Indian economy over the past couple of years is a cause for a lot of concern now. A plethora of reasons have been offered to explain the slowdown.

Corporate lobby groups have identified “high interest rates” as the villain. So too has the Government. Which Government will not prefer low(er) interest rates always? The argument for lower interest rates as a key impediment to growth stems from downplaying other factors. For instance, the government feels that not much importance need be placed on policy paralysis. After all, didn’t problems such as infrastructure deficits, high subsidies, budget deficits exist even in the high growth period? (The new RBI Governor said the same thing recently). But, there was still high growth. Therefore, the key differentiator is high interest rates.

But, the RBI (under the last Governor) pointed out that real lending rates (nominal rates adjusted for inflation) now are 50 per cent lower than the average level of 7 per cent that prevailed during the investment boom period of 2003-2008. Therefore, factors other than interest rates such as global uncertainties, structural constraints, loss of pro-reform policy momentum, inflation persistence and increasing business uncertainties have to be blamed, it says.

There is not much the RBI can do about global uncertainties, structural constraints and policy paralysis.

Structural constraints are not just physical infrastructural deficits. They have to be understood in a larger political-economy context where economic (fiscal) policy is driven by the preferences of the elected political party. The central bank has to keep making (monetary) policy irrespective of what the structural environment actually is.

Given this very basic framework, it is clear that the central bank must have a narrow economic objective. This should not be affected by changes in the underlying structural environment and political climate.

What can such a fundamental economic objective for the RBI be?

Monetary credibility

For any monetary authority, arguably, the only objective can be guaranteeing the credibility of the fiat money (the paper currency) which all modern economies have adopted. Only that will be appropriate for any structural environment.

The credibility of fiat money is maintained only if the purchasing power remains largely stable.

Stability does not mean an unchanging price level continuously and for all time. It just means protecting purchasing power in such a manner that it does not vitiate the overall economic environment. (Note that some level of inflation is necessary as an economic lubricant.)

So, how can instability in the purchasing power of money vitiate the overall economic environment — and in particular, the borrowing, investment and consumption decisions of firms and households?

Price stability, investments

Investment is a leap of faith by the entrepreneur that the value of money will be broadly stable for the future period(s) into which he is investing.

But, instability in the aggregate price level muddies the waters. It makes it difficult to determine whether changes in prices reflect changes in relative supply and demand or are part of on-going change in the general level of prices.

Investment decisions based on optimistic forecasts of real returns (assuming relative price changes for only the product the firm sells) come unstuck when the firm finds that price level changes are not only at the relative level, but at the aggregate level as well. The result is over or under-investment and swings in the investment cycle.

The rise in the aggregate price level — along with other factors — explains why the corporate sector’s PAT growth, which was robust at a 30 per cent CAGR between 2001-02 and 2007-08, has slowed down considerably. High profits in that period seem to have been largely good luck-driven, with output prices rising ahead of input prices. With high debt/equity, financial distress has almost inevitably followed and in turn, stress on financial institutions’ (banks’) asset quality.

The recent deceleration in investments is, therefore, also on account of the uncertainty caused by high inflation — combining with other reasons such as governance issues, tax policy changes, environment-related regulations and policy paralysis.

RBI reform imperative

It should be the paramount objective of the monetary authority to ensure that relative price level increases (changes) do not morph into aggregate price level increases (changes). That will be the central bank’s most powerful contribution to long-run output growth, high employment and financial stability.

But, India has signally failed in ensuring such an outcome. The RBI’s admission about low real interest rates is clear testimony.

A key reason for that failure is that we have had a super-accommodative monetary environment (marked by large deficits monetisation and overall central bank balance-sheet expansion) in the past 15 years. By no stretch of imagination is the RBI an inflation hawk, as is commonly believed. (Repo rate hikes are meaningless in the face of large central bank balance-sheet expansion.)

Deep institutional reform of the RBI is called for, if India is to avoid the trap of volatile investments, economic/financial instability and recurring boom/bust scenarios. The RBI must have a narrow mandate on price stability and it must deliver on that mandate.

It is no longer economically defensible to say that the RBI can be the jack of so many trades — monetary authority, exchange rate manager, debt manager (which compels money-financing of budget deficits), regulator and supervisor of banks and NBFCs.

That is anachronistic in today’s complex economic environment. And, is a sure recipe for sub-optimal overall outcomes as is being proved by the (high) inflation stubbornness, disorderly domestic foreign exchange markets, volatile investments and significant strains on financial sector asset quality.

Delivering domestic monetary integrity would also deliver India from the capriciousness of global financial markets. We need not bother whether there is QE or not.

(The author is a Chennai-based financial consultant.)

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