A textbook response

Quite expectedly, the Reserve Bank of India (RBI) has not reduced its benchmark lending rate (‘repo’) in its latest Monetary Policy Review. Nor has it lowered the cash reserve ratio (CRR) – the portion of bank deposits to be compulsorily kept with the RBI without earning any interest. Although the statutory liquidity ratio (SLR) – the proportion that has to be mandatorily invested in government securities – has been brought down, it has little meaning in a context where the cost of funds matters more than mere availability. Banks are currently holding some 30.5 per cent of their aggregate deposits in various sovereign papers, as against the SLR requirement of 24 per cent, now pruned to 23 per cent. The excess investments, working out to well over Rs 400,000 crore, indicate either that there aren’t many takers for bank funds at present rates, or enough projects free of usual implementation hurdles, or both. But banks can lower lending rates only if their cost of deposits comes down (difficult when the public has alternative savings avenues in gold or real estate) or they are able to borrow cheaper from the RBI. By turning down the latter option, and also keeping the CRR unchanged, the RBI has basically made it impossible for banks to cut rates.

In doing so, the RBI, as before, has accorded priority to “containing inflation and lowering inflation expectations”. One can question the relevance of this stance, when inflation today has largely to do with food and high interest rates cannot fix vegetable prices nor influence the course of the monsoon. Monetary policy is effective only against non-food manufactured products or ‘core’ inflation, which is ruling at 4.8 per cent. That should not be as big a concern, with GDP growth decelerating over four successive quarters to 5.2 per cent in January-March, industrial output rising by a measly 0.8 per cent in April-May, and capital goods production contracting in nine out of the past 11 months. The last figure, pointing to a complete drying up of investments in the economy, is something that ought to really disturb policymakers — RBI included — now.

All this is not to say that the risks from inflation have subsided. It is only to emphasise the ineffectiveness of monetary policy in combating the type of inflation being experienced — primarily food-based — and the simultaneous damage that high interest rates can cause in a growth-cum-investment slowdown scenario. In a developing economy where average purchasing power is low, the only permanent solution to inflation is investing in factories and infrastructure that deliver goods that people need in ever-larger quantities. In our obsessive concern with fighting inflation, there is a danger of also losing sight of the root cause: The Government doing nothing about managing its finances or removing bottlenecks that inhibit investment flows.

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