For reviving the investment cycle and overall growth, the need for front loading the economic reform process cannot but be overstressed. In this context, the signal given in the mid-quarter monetary policy review is a bit disappointing. Additional release of liquidity of around Rs.17,000 crore need not necessarily bring down the interest rate structure for industry and infrastructure projects. In particular, small and medium scale industry, which form an important part of the manufacturing value chain, will continue to suffer. The key question is, can rates be brought down by the central bank when inflation is hovering around 7.5%? It’s a bit of a chicken and egg story; the increase in inflation in recent months was on account of an increase in imported input costs due to rupee depreciation. The rupee was depreciating as the current account deficit could not be met through foreign direct investment (FDI) and foreign institutional investment (FII) inflows. These had dried up due to poor investment conditions in the country and relatively low gross domestic product (GDP) growth expectations. In such a situation, it would be better to focus on growth; rate reduction is one of the enablers in this process. Another aspect that we need to keep in mind is that the government is the largest borrower in the country. A reduction in interest rates benefits it more than anyone else. Around 21% of the total budget expenditure goes in interest payments. Ironically, the repayment of debt as a percentage of total budget expenditure is around 8-9%.
After a prolonged period of inaction on the fiscal front, the government has already started becoming proactive. A series of confidence-building measures has been initiated. The government has lowered the subsidy on diesel and in a roundabout manner on cooking gas. Secondly, a disinvestment process is on the anvil. Hopefully, a national investment board will come up too.
In order to bridge the current account deficit and rev up the investment process, the government has announced that it will welcome FDI in aviation and multi-brand retail. Pursuing a similar tone earlier, the decision on GAAR (general anti-avoidance rules) has been postponed and retrospective taxation has been kept in abeyance. The intervention in coal block reallocation has been selective. Unless government progresses cautiously, it runs the risk of paralysing the power sector along with steel and cement. Not only will it affect industrial output and real GDP growth, it would also have an adverse impact on the banking sector, leading to a substantial increase in bad loans.
High repo rates with a transmission lag feed into the interest structure of the entire country including 10-year G-Sec (government of India securities) rates. This can lead to accelerated preemption of the financial savings by the government and crowding out of private investments. Both these developments have a negative impact on investment and growth. The negative impact of the higher interest rate on inflation in India has not been established conclusively. However, the negative impact on growth with a two-quarter transmission lag is statistically significant. This is one part of the story; the other issue is maintaining a high cash reserve ratio (CRR) converts a part of the banking sector’s resources into resources without any yield. At a time when the non-performing assets could be mounting because of the banking sector’s exposure to recession-hit industries, it is but natural for bankers to question the practice of maintaining a high CRR level. The marginal reduction in CRR in the mid-quarter monetary policy review is at best a goodwill gesture.
If we are serious about front loading the growth process then the changes in monetary policy have to be in sync with the fiscal policy and the investment enhancement measures envisaged currently. Consequently, without a substantial change in repo rate of at least 100 basis points in the next six months not much can be achieved.
Siddhartha Roy is an economic advisor Tata group