Desperate measures

So long as the government retains its obsession with regulating the deficit, irrespective of the state of supply in the economy, growth is bound to be a casualty.

IN an uncharacteristic move, India's conservative central bank has sought to introduce significant changes in its monetary policy in its mid-year review, released on October 22. It has decided to slash the cash reserve ratio from 7.5 per cent to 5.5 per cent in two quick stages to allow additional liquidity in the system. It has reduced the bank rate, or the central bank's reference rate for interest, by half a percentage point.

The motive behind these moves is clear: to try and trigger a recovery in the economy, which is witnessing a downturn. Movements in the Index of Industrial Production (IIP), the lead indicator of the growth performance of the Indian economy, point to a significant slowdown in the growth of the economy. The IIP for the five-month period of April-August 2001 increased by just 2.2 per cent relative to the corresponding period of the previous year, as compared with 5.6 per cent during the April-August 2000.

Thus, even before the September 11 terrorist attacks in New York and Washington, India's economy was experiencing a deceleration in growth for some time. According to the quick estimates of quarterly GDP (Gross Domestic Product) growth released by the Central Statistical Organisation (CSO), the Indian economy, which had been averaging a rate of growth of 6 per cent during the four quarters between July 2000 and August 2001, experienced a decline in growth rate to 5 per cent and 3.8 per cent respectively over the subsequent two quarters. The rate of growth stood at 4.4 per cent during the first quarter (April-June) of 2001-02. Thus a longer-term tendency towards deceleration has been visible for quite some time.

This deceleration comes at a time when there are virtually no supply-side constraints on growth. In all areas Indian industry is saddled with unutilised capacity. There is no storage space left to accommodate the government's food stocks. And foreign exchange reserves are at a comfortable level of $45 billion, which gives the government the flexibility to import any tradable that is in short supply. This implies that growth is constrained from the side of demand. Investment demand has remained sluggish for some time. And industry's experience with offtake and inventories corroborates the secondary evidence that consumer demand, which was buoyant during the high growth years of 1994-95 and 1995-96, as well as in 1999-2000, has slackened substantially.

Combine these indicators of slack demand conditions with evidence that inflation has been running at unusually low levels, and the likelihood of the economy experiencing a deflationary collapse is more than real. In fact, as the Reserve Bank of India (RBI) itself notes, annual inflation as measured by variations in the Wholesale Price Index (WPI) was only 3.2 per cent on a point-to-point basis on October 6, 2001 as against 7.4 per cent a year ago. However, annual inflation, as measured by the Consumer Price Index (CPI) for industrial workers, on a point-to-point basis was 5.2 per cent in August 2001 as against 4 per cent a year ago.

Low inflation, combined with slow growth, has forced the central bank to shift focus from its conventional objective of controlling the price level, to a more pro-active one of stimulating growth. But the explanation for the seriousness that the central bank has brought to bear on the task of reviving growth lies elsewhere.

Historically, the task of triggering a recovery was assigned not to the central bank but to the government itself. The principal instruments used for the purpose were fiscal rather than monetary. Enhanced state spending, financed with new taxes or with borrowing from the central bank or the open market, was the means by which slack private demand that led to slow growth was compensated for.

All that, however, was true when Keynesian-type perspectives dominated policy-making. But with the ascendance of supply-side economics in the developed industrial countries, and its spread in the garb of International Monetary Fund-style "reform" to the developing countries, not only was slack demand seen as less of a problem but intervention by the state through fiscal means in the functioning of the economic mechanism was seen as distortionary and inefficient. Deficit-financed spending by the state, which affected the functioning of the market for credit, was seen as the principal economic problem in these countries. Not only was such "autonomous" spending perceived to be the principal cause for crises resulting from inflationary causes, but to the extent that it was financed with borrowing from the central bank, it was seen as limiting the freedom of the central bank to frame an appropriate monetary policy and use monetary levers to influence the functioning of the economy.

THE influence of this "finance-driven" perspective has had two consequences in India. First, it has resulted in an obsession with reducing and capping the fiscal deficit at a time when liberalisation-related factors have reduced the tax-GDP ratio, and therefore the amount of resources available with the state to finance expenditures. Second, it has resulted in the fact that even to the extent that a deficit persists on the government's budget, that deficit cannot be financed by borrowing from the central bank, but has to be financed by borrowing from the open market. With this intent, the Finance Ministry and the RBI had worked out and implemented an agreement which prevents the government from periodically issuing ad hoc treasury bills to finance a part of its deficit.

With hindsight it is clear that this agreement has substantially curtailed room for manoeuvre for the government, in terms of providing a fiscal stimulus to revive economic growth in periods of slackening demand. With the size of the deficit being controlled at a time when the tax-GDP ratio is falling, the expenditure the government can undertake is severely limited. And as deficits are financed with high-interest open market loans as opposed to the far cheaper loans that were available from the central bank in the past, the share of the government's limited expenditure that is pre-empted by interest payments tends to rise.

This loss of the fiscal lever was seen as a small price to pay for the greater autonomy the new regime affords the bank and the greater ability provided by that regime to the central bank to use monetary levers to stabilise the economy. This view, held by advocates of reform, was strengthened by the rather early success achieved after the 1990-91 crisis in reducing inflation and the deficit on the balance of payments. What is unclear is whether this success was attributable primarily to a monetary policy effort to rein in the growth of money supply and increase the cost of credit. Fiscal compression combined with a fall within the unit value indices or prices of imports could have also delivered these results. In fact, circumstantial evidence suggests that both these factors did play an important role.

THE ambiguity regarding the factors responsible for stabilisation is of significance because success on this front diverted attention away from an analysis of the efficacy of monetary policy, which was being made the principal means for macroeconomic regulation of the economy. There are two ways in which monetary policy can seek to affect real variables. It can affect the level of potential liquidity in the system, rendering the access to credit of investors and consumers easier or more difficult. Or it can alter the cost of credit, making it cheaper or more expensive for investors and consumers to borrow to finance their expenditures. A regime which privileges monetary policy would see enhanced access to liquidity at cheaper interest rates as the means to revive flagging economic growth. It is believed that investors would exploit the availability of cheap credit to undertake capital expenditures and simultaneously consumers would increase their spending, triggering a recovery.

In India, long before the onset of recessionary trends in the economy, the central bank had made a transition from a tight money policy aimed at stabilising the system and dampening inflation to an easy money policy with lower interest rates aimed at stimulating investment and growth. As a result, for quite some time now the banks have been awash with funds and in search of creditworthy borrowers. They were helped in the search by the presence of a government, shunned by the central bank, as a major borrower in the market.

The difficulty was that despite this recourse to a liquidity-enhancing strategy, interest rates proved to be quite sticky. They fell in nominal terms, but not enough to make much of a difference to real interest rates, since inflation too was on the decline. This led to the view that the problem of reducing the level of interest rates in India was not purely a monetary one, but structural in nature.

To quote the RBI, the following are some of the "factors which reduce downward flexibility in the interest rate structure in India":

"Banks, particularly public sector banks, continue to be the primary mobilisers of domestic financial savings (in addition to Provident Funds, Small Saving Schemes, and Life Insurance Corporation). Holders of term deposits in banks generally belong to fixed income groups and expect a reasonable nominal interest rate, in excess of the long-term rate of inflation. The recent reductions in deposit rates and return on small savings have caused widespread concern among depositors because of lack of other risk-free avenues for financial savings. This constrains the ability of banks to effect further reduction in their lending rates without affecting their deposit mobilisation and the growth of financial savings over the medium-term.

"Banks have been given the freedom to offer "variable" interest rates on longer-term deposits. However, for various reasons, the preference of depositors as well as the traditional practice with banks tended to favour fixed interest rates on term deposits. This practice has effectively reduced the flexibility that banks have in lowering their lending rates in the short run, since the rates on the existing stock of deposits cannot be lowered.

"For public sector banks, the average cost of funds is over 7.0 per cent, and for many private sector banks, the average cost is even higher. The non-interest operating expenses generally work out to 2.5 to 3.0 per cent of total assets, putting pressure on the required spread over cost of funds. Relatively high overhang of Non-Performing Assets (NPAs) pushes up further the lending rates.

"There is a persistent and large volume of market borrowing requirements of the government giving an upward bias to the interest rate structure.

"In view of the above rigidities in cost, spread and tenor of deposits, the link between variation in the RBI's bank rate and the actual lending rates of banks, particularly at lower levels, is not as strong in India as in industrialised countries. PLRs of banks for commercial credit are entirely within the purview of the banks, and are not set by the Reserve Bank. Decisions in regard to interest rates, therefore, have to be taken by banks themselves in the light of various factors, including their own cost of funds, their transaction costs, interest rates ruling in the non-banking sector, etc."

THE basic point is of course that while the RBI may attempt to bring down nominal interest rates through changes in its own discount rate, the real interest need not go down commensurately especially in a period of depressed expectations. Unfortunately for the RBI and the government, they now have few other levers available in their strategy to deal with the slowdown in the economy.

Hence, as elsewhere in the world, the current deflationary trends are being confronted not with a fiscal stimulus but with renewed efforts to reduce interest rates and increase liquidity in the system. That is what the mid-term monetary policy statement sets out to do. However, once again, as elsewhere in the world, the evidence is now overwhelming that both investment and consumption spending do not respond adequately, if at all, to the availability of cheap credit.

Consumers spend when incomes rise, incomes rise when investment is buoyant, and investment tends to be buoyant when there are adequate "inducements" to invest. In India, exports have never provided the inducement to investment. In any case, with the world economy sluggish, exports cannot provide the stimulus now. The inducement must come from an expansion in the home market, which seems clearly dependent on a fiscal stimulus.

So long as the government retains its obsession with capping and regulating the deficit, irrespective of the state of supply in the economy growth is bound to be a casualty. Attempts to tinker with or even dramatically alter monetary policy, as reflected in the mid-year credit policy statement, would not change this situation.