The Reserve Bank of India's credit policy review indicates that the emphasis on monetary measures continues, even though economic circumstances suggest that an appropriately structured fiscal stimulus is the need of the hour.
OVER the last three days of October, the financial media were completely preoccupied with the Reserve Bank of India's (RBI) mid-term review of credit policy for 2002-03, released on October 29. This intensive interest in the RBI Governor's twice-in-a-year "reviews" is a recent phenomenon. Until a few years back these statements were of interest principally to bankers and other sections of the financial community. Now the interest seems to be more widespread, judging by the extent of media coverage of the statement itself and of the responses to it.
Financial sector interest in the mid-year reviews is understandable, since they include announcements or projections of changes in monetary policy. This time around, among the many changes announced by the Governor, the three that were noted most were:
1. A 25-basis points (or a quarter of a percentage point) reduction in the Bank Rate (or the rate at which the central banks loan funds to the banking system);
2. A similar cut in the repo (or repurchase option) rate, which is the implicit rate at which securities can be parked with the central bank for short periods in return for funds; and
3. A reduction in the cash reserve ratio (CRR) required to be maintained by banks from 5 to 4.75 per cent. In sum, at the core of the policy change announced by the monetary and credit policy is a continuation of the RBI's effort to reduce nominal interest rates by reducing the cost at which the commercial banking system can access funds from the central bank and to increase the ability of banks to provide credit to the corporate sector and the public at large. Lower nominal interest rates and easier liquidity conditions are the mantras.
The central bank's decisions on these matters now command wider attention for the reason that in the post-liberalisation era, monetary adjustments of this kind are considered an important stimulus to higher growth. After an initial period at the start of the reforms, when in the name of stabilisation the central bank maintained an extremely high interest rate and tight control over money supply, the RBI has for more than five years now been pushing to reduce interest rates and ensure easy liquidity conditions.
This shift over time from a stringent to an extremely relaxed monetary policy stance occurred because the inflation rate fell to extremely low levels, allowing the RBI to shift its attention from its declared principal concern of controlling inflation to that of facilitating growth. As the RBI makes clear, inflation is not a problem at all. Annual inflation, as measured by variations in the Wholesale Price Index (base: 1993-94=100) was on an average ruling at 2.3 per cent as on October 12, 2002 against 6.3 per cent the previous year. Measured by variations in the Consumer Price Index for industrial workers on a point-to-point basis, it was 3.9 per cent in August 2002 as against 5.2 per cent a year earlier.
Inflation fell for a combination of reasons: the comfortable food stocks created by consecutive good monsoons, the availability of adequate foreign reserves that could be used at appropriate points of time to deal with severe shortages of particular commodities, the reduction in domestic demand and absorption as a result of the reform-led curtailment of government expenditures and easier access to imports as well as the fall in import prices ensured by liberalisation and the slowing of global growth. Together these developments ensured the supply at reasonable prices of most commodities, resulting in downward pressure on the price level.
This encouraged a shift in focus to policies that could spur growth, especially since there was a widely held view that slow growth was the result of high interest rates. The transition to a regime of lower interest rates and easy money was also necessitated by two consequences of the financial reform process adopted since the early 1990s. First, the more conventional means of spurring growth through an increase in government expenditures were no longer seen as feasible. Tax revenues to finance such expenditures could not be mobilised by raising tax rates, it was argued, since that would generate disincentives for private sector savings and investment, which were considered the engine for growth under the new dispensation. And, deficit financing as a means to undertake such expenditures was ruled out by the fact that one of the aims of reform was to curtail the deficit on the government's budget, and prevent it from subverting the effort to control inflation through the use of the monetary levers. Thus, if growth had to be stimulated by the government at all, monetary rather than fiscal levers were the ones that were seen as appropriate.
Secondly, the philosophy of reform was one in which reliance on fiscal policy had to be given up in favour of a greater role for monetary policy initiatives to be pursued by a more autonomous and independent central bank. It should be obvious that the only monetary policy instruments available with the central bank to deal with the problem of slow growth that emerged in the period after 1996-97 are those of increasing credit availability and reducing the rate of interest at which such credit can be accessed. And it must be said to the credit of the RBI that, with some help from the government in the form of reduction of interest rates on small savings schemes, it has been able to reduce nominal interest rates and improve credit availability, though the excess liquidity in the system is partly because credit off-take has fallen far short of expectations because of slow growth.
This aspect of the liquidity situation in the economy points to one feature of the current economic conjuncture, which the RBI's review glosses over: growth in the system, which slowed after the mini-boom of the mid-1990s, is still sluggish. In other words, easy credit conditions and lower nominal interest rates relative to the early and mid-1990s are proving inadequate to reverse the slow rate of non-agricultural growth in the system. In the RBI's own words: "During 2002-03 so far, financial markets in India have been generally stable, liquidity has been adequate, and the interest rate environment has also been favourable to promote investments." What it refuses to recognise is that growth has been disappointing, despite these facilitating trends. In fact, the RBI suggests that the non-agricultural sector is experiencing a recovery and the additional measures it is putting in place through policies announced as part of the recent review would see a transition to a situation of robust growth.
Unfortunately for the RBI, it is being forced to scale down its own expectations of what the rate of growth of GDP (gross domestic product) would be. It admits that GDP growth over 2002-03 is likely to be in the range of 5 to 5.5 per cent as against the earlier projection of 6 to 6.5 per cent. But the mid-term credit policy statement attributes this solely to the shortfall in agricultural production owing to the poor monsoon, and assumes that this has occurred despite a recovery in industrial production during the first half of this financial year. To quote the statement: "On balance, the present indications are that agricultural GDP for the year 2002-03 will decline by around 1.5 per cent. On the other hand, there are indications of a recovery in industrial production during the first half of the current year."
It is indeed true that the Index of Industrial Production for the period April-August points to a rate of growth of 4.9 per cent this year as compared with 2.4 per cent during the corresponding period of the previous year. But this rate is extremely poor when compared to the high rate achieved during the immediate post-reform boom of the mid-1990s or the growth rates recorded during the 1980s. Further, such small, short-term improvements in the rate of industrial growth have been characteristic of the period since 1997, during which the trend rate of industrial growth has dipped substantially. The RBI's use of its monetary levers has obviously not been able to change that trend.
One consequence of this persistence of slow growth is that despite easy liquidity, credit off-take by the non-agricultural sector has been disappointing. As the RBI review reveals, excluding the impact of mergers, scheduled commercial banks' credit increased by 6.6 per cent (Rs.38,800 crores) between April 1 and October 4, 2002 as against 6.8 per cent (Rs.34,700 crores) in the corresponding period of the previous year.
The other consequence of slow growth has been the fact that non-oil imports, especially non-oil, non-bulk imports, have risen only marginally despite the liberalisation of imports. The salutary effect this has had on India's trade balance has combined with large remittances and significant capital inflows, to ensure a surplus on the balance of payments that has been matched by the accumulation of foreign exchange reserves with the RBI. Looked at differently, to prevent the easy availability of foreign exchange in the economy triggering an appreciation of the rupee, the RBI was forced to buy into the excess supply of dollars, leading to the $18 billion reserve accumulation over the year ending October.
This is what accounts for the embarrassingly large accumulation of foreign exchange reserves in the system, from $45.2 billion as on October 26, 2001 to $64 billion by October 25, 2002, an increase of $18.8 billion. Rather than seeking to understand this peculiar accumulation of reserves that are being invested at rates far lower than the returns earned by (paid out to) those responsible for the initial inflow, the statement seeks to defend the development as an indicator of prudent external sector management.
Thus the principal problem that confronts the Indian economy is that of slow growth, which rules despite the large stocks of food in the system, the huge reserves of foreign exchange and the massive excess capacity in much of the industrial sector. Together with the extremely low rate of inflation in the system when measured by historical standards, this problem of slow growth clearly suggests that the reform has imparted a deflationary bias to the system, which needs correction. Both economic logic and experience suggest that in order to deal with that bias the government must rethink its stand that it is monetary rather fiscal policy initiatives that need to be emphasised. But so long as the current thinking on "financial reform" persists, this is unlikely to occur.
Not surprisingly, the mid-term review for 2002-03 promises more of the same. By further reducing the bank rate and the repo rate, by enhancing liquidity in the system through cuts in the CRR, and by encouraging banks to reduce spreads over PLR, the RBI is still trying to use the twin levers of lower interest rates and easy liquidity to impart some dynamism to the system. This failure to change the way it looks at the big picture has been combined with a large number of specific micro-level policies and adjustments that are unlikely to impact on the problem of slow growth confronting the economy today.