Wrong diagnosis, wrong prescription

The announcement by the Reserve Bank of India (RBI) of the relaxation in policy rates and the Cash Reserve Ratio by 25 basis points each is the result of the wrong diagnosis of the current situation that is no different materially from what it was on the occasion of the last review. The basic causes are the wrong benchmarks used for measuring inflation and liquidity.

The RBI justifies its stand citing moderation in inflation, as measured by the Wholesale Price Index (WPI). When the aam admi goes to the market, what he pays is the consumer price, not the wholesale price.

And the RBI has this to say on the Consumer Price Index (CPI): “In contrast to WPI inflation, CPI inflation, as measured by the new consumer price index, rose to 10.6 per cent in December, largely reflecting the surge in food inflation. Excluding food and fuel groups, CPI inflation remained unchanged at 8.4 per cent during the third quarter.”

The irrelevance of core inflation, as defined in the West, in the Indian context has already been dealt with in “Rate cut advocates are wrong” ( Business Line , January 27).

The core inflation has remained the same in CPI. The expectation behind the reduction in the policy rates is that it will be passed on to borrowers, stimulating investment. Given the rising risk aversion due to the growth in non-performing assets (NPAs), it is likely that the policy change will be reflected only in deposit rates.

Banks are ever anxious to protect their margins. Lending rates are fixed factoring in the general level of NPAs, so that good borrowers pay for the sins of the bad ones — an instance of moral hazard. Investment depends on both internal and external demand for goods, the latter being not easily amenable to domestic policy.

Will the internal demand for goods rise when the level of prices — be they of necessities, comforts or luxuries — is very high?

Liquidity

The second source of wrong diagnosis is the state of liquidity in the economy. There is no clear enunciation of the concept of liquidity used by the central bank. It seems to be measured only by the transactions under Liquidity Adjustment Facility.

In the past, under a different management, there used to be measures of the overhang of liquidity. The bank says that liquidity conditions tightened in Q3 of 2012-13 due to the build-up of government cash balances and strong currency demand. It resumed outright open market operations (OMOs). In 2012-13 so far, it has infused liquidity of Rs 130,000 crore through outright OMOs. There are two criticisms of this aspect of the review — one is technical and the other is based on common sense.

I had earlier suggested that surplus government deposits in the RBI could be auctioned among the commercial banks so that they fetch interest for the owner and alleviate liquidity shortage by returning to the market the funds absorbed through advance tax payments. A few reviews ago, the RBI said that it would examine the proposal. One does not know its outcome. It would be better than injecting primary liquidity through buybacks.

The second objection is to government borrowing in the market when it has large funds with the RBI. Can it not adopt the just-in-time policy of firms in managing inventories?

Wage-price spiral

The review admits that, going forward, risks remain from suppressed inflation, pressure on food prices and high inflation expectations getting entrenched into the wage price spiral.

The inflation path for 2013-14 could face downward rigidity. Hence, it is all the more surprising that the bank has decided to relax its policy stance.

One factor that is abundantly clear is the wage-price spiral afflicting the economy.

Contrary to the Keynesian assumption that workers suffer from money illusion, our staff are intelligent enough to distinguish between nominal and real wages, thanks to the trade unions and farmers’ associations. It was brought out well in the econometric exercise included in the latest Annual Report of the central bank.

How does the economy break out of the vicious circle? In the past, I have dealt with the concept of inertial inflation that refuses to move from its near-equilibrium position due to expectations.

The RBI’s downward revision of WPI inflation from 7.5 per cent to 6.8 per cent by the end of the year is not likely to come true. Seasonal effects are getting blurred due to the underlying trend of accelerating aggregate demand.

To give one instance, in the distant past, winter was the flush time when the dairyman reduced price by Rs 1 per litre that would go up again in summer, the lean season, by the same amount.

During the last few years, milk prices have been showing a rising trend swamping the seasonal effect. And we claim to be the largest producers of milk in the world!

What the inertial inflation needs to being overcome is a shock to the equilibrium on the supply side.

I have suggested free distribution of rice and wheat to the families below the poverty line, that would also reduce the rotting stocks in the overflowing granaries of government. It will prepare them for further additions in the coming wheat procurement season.

If the Government calculates the cost involved in additional subsidy, it will not be unmanageable if one reckons with the amount of money lost due to the poor storage of grains apart from other costs. The electoral benefit will be immeasurable!

(The author is a Mumbai-based economic consultant.)

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