Monetary Policy: Desperate Measures

Oct 30th 2001, C.P. Chandrasekhar

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 the 22nd of October. It has decided to slash the cash reserve ratio from 7.5 to 5.5 per cent in two quick stages to allow for the release of additional liquidity into the system. It has reduced the Bank Rate, or the central banks' reference rate for interest by half a percentage point.
The motive behind these moves is all too clear. It is to try and trigger a recovery in the economy, which is witnessing a downturn As has been noted earlier in these columns, movements in the Index of Industrial Production, the lead indicator of the growth performance of the Indian economy, point to a significant slowdown in growth of the economy. The IIP for the five-month period April-August 2001, increased by just 2.2 per cent relative the corresponding period of the previous year, as compared with the 5.6 per cent increase registered during the April-August period of 2000.
Thus even before the September 11 terrorist attacks in New York and Washington, India's economy has been experiencing a deceleration in growth. In fact, the deceleration has been with us for some time now. According to the quick estimates of quarterly GDP growth released by the CSO, the Indian economy, which had been averaging a rate of growth of 6.0 per cent during the four quarters between July 2000 and August 2001, experienced a decline in growth rate to 5 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 now.
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 foodstocks. And, foreign exchange reserves are at a comfortable $45 billion, give 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 quite some time now. And, industry experience with offtake and inventories corroborate the secondary evidence that consumer demand, which was buoyant during the high growth years 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 for quite some time now, and the likelihood of the economy experience a deflationary collapse is more than real. In fact, as the RBI itself notes annual inflation, as measured by variations in Wholesale Price Index (WPI), stppd at 3.2 per cent on a point-to-point basis, on October 6, 2001 as against 7.4 per cent a year ago.  Annual inflation, as measured by Consumer Price Index (CPI) for industrial workers on a point-to-point basis, was 5.2 per cent in August 2001 as against 4.0 per cent a year ago.
Low inflation combined with slow growth has forced the 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 earnestness 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 also 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 IMF-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. What is more, 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 its 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 with borrowing from the open market. With this intent, the Finance Ministry and the Reserve Bank of India had worked out an 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 the room for manoeuvre of the government to provide a fiscal stimulus to revive economic growth in periods of slackening demand. With the size of the deficit being controlled when the the tax-GDP ratio is falling, the expenditure that 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 was pre-empted by interest payments tends to rise.

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