Making a collage out of disparate policy themes that seem to dominate our economic scenario is indeed a difficult exercise. However, in recent months, some uniformity in views has started appearing. Growth has become the dominant theme. The issue of inflation is being tackled from monetary and fiscal sides simultaneously. This is clearly encouraging in view of the fact that the Indian economy often had a counter-cyclical monetary policy coupled with a pro-cyclical fiscal policy. Pressing the brake and accelerator at the same time can lead to unpleasant consequences.
Before getting into a discussion of the monetary policy, the cash reserve ratio (CRR), or the portion of deposits that banks need to keep with the Reserve Bank of India (RBI), and the repo rate, etc., it would be useful to delineate the current context.
After a long lapse, there is adequate focus on the fiscal deficit, particularly on the expenditure side. Rationalizing subsidies is progressing in a well-charted direction. On the revenue side, hopefully, it is recognized that the buoyancy in revenue growth is clearly dependent on gross domestic product (GDP) growth and tinkering with the tax-GDP ratio or tax rates can have a deleterious impact in the stagflationary context.
GDP growth in 2012-13 is unlikely to go significantly beyond 5.5% and the 12-month moving average of industrial production has got stymied at 1.1%. In order to break away from this in 2013-14, one needs to focus on the drivers of growth like consumption and investment.
At this stage, it may be useful to bring out an important lesson from 2008-09 when we faced a growth crisis on account of the global financial meltdown. We got out of it by exploiting the consumption stimulus route. Some of the key developments were the agricultural loan waiver, implementation of MGNREGA (Mahatma Gandhi National Rural Employment Guarantee Act), and hikes in the salaries of government employees. Along with these came some tax rate reductions.
Possibly the policymakers wanted visible results quickly. This was achieved in terms of a higher growth rate of GDP the next year. However, this process is not sustainable. While tax concessions can be rolled back, salary increases and social benefit schemes continue to roll on. It is indeed true that post-MGNREGA, rural wages have increased at 18% per annum in nominal terms and 7.5% in real terms between 2008-09 to 2011-12.
MGNREGA is providing the floor for rural wages (nobody can give below this level) and this is leading to wage inflation.
Finally, with more cash with a section of the households, which have got higher expenditure elasticity for food, the demand for food items such as cereals, pulses, milk, meat, fish, egg, fruit and vegetables has gone up.
The supply on account of low yield and inadequate supply chain management has remained inelastic and, consequently, prices have gone up. Higher price of inputs, feed and fodder only exacerbated the problem. A single-handed battle using the repo rate and CRR is of little use in this context.
Interestingly, the core inflation, or non-food and non-fuel manufacturing goods inflation, on which monetary policy has a more direct impact, came down to 4.25% in December on a year-on-year basis, showing that inflationary expectations are low. Further, the cumulative output gap of the last four quarters is around 3%. This, coupled with declining core inflation, should make the case for a rate reduction.
As enhancing growth is the dominant theme, trying to pursue it by encouraging investment can be a more sustainable alternative than putting overwhelming importance on consumption. However, for pursuing the investment expansion-based option, a key obstacle is high interest rates.
The mid-year review clearly indicates that interest as a percentage of operating profits of non-government and non-financial companies, “increased from 15.2% in Q4 2009-10 to 30.3% in Q1 2012-13”. Around the same time, new project investment came down from 28.5% of GDP to 9.7% of GDP, according to Centre for Monitoring Indian Economy Pvt. Ltd’s capex data.
This is not to suggest that interest rates are the only cause; there are other factors at play, too, hindering project implementation such as land acquisition and regulatory clearances, etc. For expansion of existing projects and the small- and medium-scale industry, high interest rates are a well-recognized deterrent.
To kick-start the investment and overall growth process, particularly in manufacturing and infrastructure, a sharp rate cut is more than overdue; a mere 25 basis point reduction will be too little and too late, given the transmission lag of the banking system. One basis point is one-hundredth of a percentage point.
Siddhartha Roy is economic adviser, Tata Group.
The Reserve Bank of India will unveil its quarterly monetary policy on 29 January amid widespread expectations of a rate cut as well as a cut in banks’ cash reserve ratio to prop up investment demand in a slowing economy. This is first of a series of articles, written by well-known economists, in the run up to the policy