BackCan Raghuram Rajan do a Bimal Jalan?
RBI under Bimal Jalan managed to cut rates by almost 7 percentage points, reducing the interest costs of firms as well as bolstering bank earnings
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What now?
The stomach-churning fall in financial markets across the world this week is a sign of growing realization that China is in trouble. The rest of the world has good reason to worry. A sharp slowdown in the second largest economy is bound to hurt the world economy.
China has been contributing around a third of total global growth over the past decade. And the sudden devaluation of its currency in a bid to boost exports could specifically hurt many Asian economies with which it competes in the world markets.
Remember: it was the sharp devaluation of the yuan in 1994 that set the stage for the Asian financial crisis three years later.
Much will now depend on how various large economies respond. China has little dry powder left in its armoury. It cannot unleash another credit binge or increase public spending, given the fragile state of its financial system and the high fiscal deficit of close to 10% of gross domestic product.
The decision to stimulate economic activity through a currency adjustment is one indication that there is little space for monetary or fiscal stimulus. Anyway, stimulus policies have diminishing returns, especially when they are trying to deal with underlying structural problems such as overinvestment rather than a textbook shock to effective demand.
There is a lot of hopeful talk in the financial markets that the US will step in with further stimulus, or at least a postponement of its imminent interest rate hike by the end of the year. A look at past episodes of financial instability across the world provides an interesting insight: US policy is driven more by domestic rather than global considerations.
The two big crises originating in the emerging markets were the Mexican tequila crisis of 1994 and the Asian crisis of 1997. The US continued to raise interest rates in the former case and cut rates by a modest 75 basis points in the second case. Compare that with the 525 basis points of cumulative rate cuts after the bursting of the dotcom bubble in 2001 and the end of the mortgage bubble in 2007, both of which were responses to problems originating in the US. One basis point is one-hundredth of a percentage point.
More generally, if one adds Japan and Europe as well, a synchronized global policy response seems unlikely. What happened in early 2009 was a different matter. All major countries signed on to a plan for global stimulus because their economies had moved down in tandem. That is no longer the case.
What can India do? The recent fall in the rupee is akin to an interest rate cut in terms of its macroeconomic impact. The sharp decline in global commodity prices could act as a tax cut through their impact on real incomes. Some of the positive impact has already been seen in the expansion of operating margins in the quarter ended June. A decomposition of the wholesale price index by J.P. Morgan India economist Sajjid Chinoy shows that most of the deflation there is because of the sharp decline of input prices rather than output prices.
The biggest debate will continue to be on the level of interest rates. One way to look at the issue is by using the output gap (or whether actual growth is less or more than potential growth) and the inflation gap (or whether the latest inflation is above or below the official central bank target). India is growing below potential. And inflation is likely to undershoot the January target. In fact, the most recent data does suggest that India has some space for further rate cuts once the impact of the previous three rate cuts have filtered into the real economy with the usual lag.
But the bigger question is this one: Is there space for dramatic rate cuts? This column had previously written about what lessons can be learnt from the economic recovery India saw in the early years of the century. Now is a good time to revisit that period to answer the interest rate question.
Look at the chart. The Reserve Bank of India under Bimal Jalan had managed to bring down interest rates on benchmark 10-year bonds by almost 7 percentage points, thus reducing the interest costs of firms as well as bolstering bank earnings through a splendid bond rally. Then, as now, the two big problems were overleveraged companies and banks with a massive bad loan problem.
Can Raghuram Rajan repeat the act?
There are three important differences between now and then. First, interest rates were far higher when the rate cuts began after 1998, and hence had more scope to fall. Second, the disinflation was generalized rather than being so heavily dependent on lower commodity prices. Third, consumer price inflation went all the way down to zero in 1999, and it was rarely above 4% in the next few years.
But there is a broader lesson: the sustained decline in inflation in the late 1990s created space for lower interest rates, the cleaning up of balance sheets and the unprecedented economic boom in the five years from 2003.
Niranjan Rajadhyaksha is Executive Editor of Mint.
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