The unprecedented global slowdown and the subsequent deleveraging and risk aversion by banks have affected capital, foreign exchange, money, debt and credit markets significantly. The Indian economy has been adversely affected because of the global financial turmoil.
India is not decoupled from the developed economies. The extent of inter-linkages can be gauged from the depth of the present economic crisis. However, the macroeconomic impact of the crisis is relatively subsided due to the immense strength exhibited by domestic demand. Since October, regulators and policymakers have aggressively taken all possible fiscal and monetary measures to ensure that the gross domestic product continues to grow at 7-8% this fiscal.
The past few months have seen fervent monetary policy measures by the government. In this period, the Reserve Bank of India has followed an increasingly easier monetary policy. Other than cuts in key policy rates by 100-150 basis points, the cash reserve ratio (CRR)—the most immediate measure of liquidity infusion—has been brought down to 5%. As per some estimates, these monetary measures have infused about Rs1.4 trillion of liquidity into the banking system. Moreover, the government has also adopted a policy of moral suasion with public sector banks to reduce their lending rates. Hence, from the supply of funds side these efforts appear to be in the right direction. However, as a famous maxim goes, “we can take the horse to the pond but cannot make it drink”, so it is with lending. Hence, in order to boost aggregate demand, the Union government would have to rely on direct fiscal stimulus.
The policy options with the government could also be seen in another light. Economic theory generally views the prospects of monetary and fiscal policy effectiveness through the interaction of the fiscal and monetary measures. These measures are, in general, underlined by the interest rate sensitivities and their links to investment and income. A look at the investment cycle in the Indian context would reveal that both the public and private sectors have contributed to the asset formation upswing.
Data released in various economic surveys shows that while public sector investment rose from 6.3% in 2003-04 to 7.8% in 2006-07, private investment also rose substantially from 19.5% in 2003-04 to 27% in 2006-07. However, taking a historical perspective, during the time of a recession, public investment has generally tried to occupy the space vacated by private investment—the latter witnessing a sharp fall in the gloomy environment of a downturn. The rising public investment is evidenced by the announcement of fiscal stimulus packages and the continued robust projections of investment rates at historically high levels. In essence, the impact of a fiscal stimulus would be far greater on the interest rate side than the income side compared with normal times. It is more appropriate for RBI to take money market measures such as slashing reverse repo, repo and CRR to 3.5%, 5.0% and 5%, respectively, which are direct short-term measures of intervening compared with the bank rate that affects the economy through a more indirect transmission system. The central bank has already reduced some of these key rates.
Thus, in the current circumstances, a prudent and judicious mix of expansionary monetary policy with a fiscal policy, where public investment provides a strong complementarity to the private sector, would prove to be most effective.
Soumendra Dash is chief economist, CARE Ratings. Comments are welcome at firstname.lastname@example.org