It is clear the emphasis of monetary policy has shifted from inflation to growth. And a textbook approach to stimulating growth is to call for lower interest rates. But in these extraordinary times, the whole credit creation mechanism is frozen, like a deer caught in the headlights. Cutting interest rates is like honking loudly, but the deer remains still.
Also, anticipation of cuts in interest rates has a perverse incentive effects on banks. As yields fall, the price of government bonds go up. Banks that remain invested in government bonds reap capital gains, and hence do not invest in new credit. Thus, the stronger the expectation of rate cuts, the higher the tendency to park loanable funds in government securities.
Many years ago, a deputy governor had chastised this tendency as lazy banking. By a strange coincidence, we have the same deputy governor, the same behaviour, but it is no longer because of lazy banking. It is now a rational response of banks to deteriorating business outlook.
The Reserve Bank of India’s (RBI) central challenge then is how to unclog credit flow to sectors that need it the most. This problem is as old as central banking itself, and the present times don’t offer any new clues. The financial and economic crises have begun to feed on each other in a rather unpleasant way.
Thus, production cuts due to lack of working capital have now led to demand destruction and job losses due to anxiety about economic growth itself. Moreover, the prospect of deflation in commodity prices is causing consumers to postpone purchases.
The only way to break this almost self-fulfilling prophecy is harsh medicine: a strong, unorthodox dose of fiscal expansion. It has a toxic side effect—a higher fiscal deficit will cause longer-term problems of interest rates, inflation and lower growth—but it’s the only way to ensure growth surpasses 6% next year.
It is clear RBI has chosen to conserve its medicine. There could be two reasons. Either it is waiting for the earlier strong dosage (rate cuts totalling 350 basis points) to take effect. Or it is worried that too much of this dosage is making the virus of non-lending resistant to further policy doses.
Given that global rates are almost at all-time lows, rates here can go lower too. The impediments are fiscal load and, interestingly, also the postal savings rates.
However, the real hurdle is not rates, but access to credit. Bank financing has become the sole source of credit, as foreign funds and non-bank sources have dried up. Policy cajoling banks is like taking the horse to the water.
Ajit Ranade is chief economist at the Aditya Birla Group.