Over
the last three days of October this year, the financial media were
completely preoccupied with the Reserve Bank of India's mid-term review
of credit policy for the year 2002-03, released on October 29. This
interest is partly explained by the fact that these twice-in-a-year
"reviews" include announcements or projections of changes in monetary
policy. This time around, among the many changes announced by the RBI
governor, the three most noted were: (i) a 25-basis points (a quarter of
a percentage point) reduction in the Bank Rate (or the rate at which the
central banks loans funds to the banking system); (ii) 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 (iii) a reduction in the cash reserve ratio
required to be maintained by banks from 5 to 4.75 per cent. In sum, at
the core of the policy change announced by this October's monetary and
credit policy is a continuation of the RBI's effort to reduce nominal
interest rates by reducing the cost at which the 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
continuing mantra.
We must recall that 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 what is its declared principal concern
of controlling inflation to that of facilitating growth. Inflation
itself fell for a combination of reasons: the comfortable food stocks
created by consecutive good monsoons, the reduction in domestic demand
and absorption as a result of the reform-led curtailment of government
expenditures and the easier access to imports as well as the fall in
import prices ensured by liberalisation and slowing of global growth.
The transition to a lower-interest-rate and easy-money policy 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 was no longer seen
as feasible. Tax revenues to finance such expenditures could not be
mobilised, it was argued, without generating disincentives to save and
invest for the private sector, which was seen as the lead engine for
growth under the new dispensation. And, deficit financing as a means of
undertaking 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 at controlling inflation
through 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.
The RBI's mid-term credit policy statement for 2002 confirms two
relatively less-discussed tendencies in the Indian economy. First, easy
liquidity and lower nominal interest rates relative to the levels
recorded through much of 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. Second, there has been
an embarrassingly large accumulation of foreign exchange reserves in the
system, from US $ 45.2 billion as on
October 26, 2001
to US $ 64.0 billion by
October 25, 2002,
an increase of US $ 18.8 billion. Rather than seeking to understand this
peculiar accumulation of reserves, the statement seeks to defend the
development as an indicate of prudent external sector management.
Confronted by these developments the RBI has chosen either to ignore
them or justify them with seeking to explain them. For example, it is
widely known that with inflwtion being subdued for some time now, there
has been a shift in the focus of the central bank's attention from
inflation control to growth promotion. What the evidence on growth
suggests is that the central bank's strategy of using a regime of easy
liquidity and lower nominal interest rates to trigger growth has failed
to deliver results.
The RBI, however, appears to be reluctant to accept this evidence that
has been corroborated by recent trends in the index of industrial
production. While admitting that overall GDP growth for the year
2002-03 is likely to be in the range of 5.0 to 5.5 per cent as against
the earlier projection of 6.0 to 6.5 per cent, the mid-term credit
policy statement attributes this solely to the shortfall in agricultural
production due to the poor monsoon, and believes 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
April-August period 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 even 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.
One consequence of this persistence of slow growth is the fact that
despite easy liquidity, credit offtake from by the non-agricultural
sector has been disappointing. As the statement record, excluding the
impact of mergers, scheduled commercial banks' credit increased by 6.6
per cent (Rs.38,800 crore) between April 1 and October 4, 2002 as
against 6.8 per cent (Rs.34,700 crore) in the corresponding period of
the previous year. The other consequence of the slow growth has been the
fact that non-oil imports, especially non-oil, non-bulk imports have
been subdued. This combined with the fact that the higher returns
offered by the domestic financial market resulted in substantial
international investor interest and led to large capital flows, led to a
build-up of reserves, since foreign exchange inflows were being
inadequately absorbed to finance imports. In brief, to prevent 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.
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. As the RBI itself, makes clear, inflation
is not a problem at all. Annual inflation, as measured by
variations in the Wholesale Price Index (WPI) (base: 1993-94=100) was on
an average basis ruling at 2.3 as on October 12, 2002 as against 6.3 per
cent in the previous year. Measured by variations in the Consumer Price
Index (CPI) 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 ago. This
domination of slow growth over inflation and the evidence that growth
was not responding to lower nominal rates clearly requires the
government to rethink its proposition that it is monetary rather fiscal
policy initiatives that need to be emphasized. 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.
