A V Rajwade: Money supply, interest rates and growth

WORLD MONEY

No policy on the impact of money supply on inflation is complete without analysing productivity growth.

In his Weekend Ruminations on July 29, our editor pointed to the risk of the economy losing steam and/or interest rates going through the roof, within the next 12 months. An allied issue is the prospects for inflation. One of the more puzzling aspects of the current global economy is that inflation has remained subdued worldwide even when oil (and other commodity) prices are sky high. In its previous Annual Report, the Bank for International Settlements (BIS) had lauded central bank policies for inflation control "" as the central bank's central bank, one could hardly expect otherwise. On the other hand, in its latest Annual Report, for the year ended March 31, 2006, it has conceded that "the striking similarity across countries despite wide differences in monetary policy frameworks, exchange rate regimes and the configuration of other economic forces impinging on these economies, suggests that other common forces may also have played an important role. Globalisation is a natural candidate."

We in India have also seen this trend of lower inflation: from an average of 8 per cent for several decades, the rate has dropped to, say, 5 per cent a year and the RBI expects the rate to remain between 5 and 5.5 per cent "" this not only when commodity prices are very high, but when economic growth is strong and money supply growth well above the target range.

The RBI has been underemphasising the role of money supply in its monetary policy for some years now (20 million credit cards, with aggregate credit limits of, say, Rs 50,000 crore, and undrawn cash credit limits escape the conventional calculations anyway). While this is to be welcomed, the data available with our policy-makers leaves many gaps. For instance, one has not seen well analysed data on productivity growth, global and Indian capacity utilisation, and so on. The latter, in particular, is a crucial input for monetary policy. To quote the BIS once again, "the correlation between domestic goods and services inflation and measures of global output gaps has been positive and growing for advanced industrial countries, even as the sensitivity of domestic inflation to domestic output gaps has declined."

This apart, delicensing of industry and freer imports have clearly led to strong competition amongst different producers, limiting their ability to increase prices. Surely, this has had as much, if not more, to do with lower inflation as monetary policy. Again, while many macro-economic variables, particularly GDP growth, have gone up sharply during the past couple of decades, the same cannot be said about Indian banks' commercial lending: as a percentage of nominal GDP, it remains lower as compared to most Asian economies. If GDP and industrial growth has gone up, this is because industry has learned to make far more efficient use of capital. But, in this, as in productivity improvements, most of the low hanging fruit has already been picked. The law of diminishing returns would start making its influence felt and improvements would be more difficult and slower.

While looking at monetary policy and growth, one other factor needs to be taken note of. Banks had 40 per cent of their liabilities invested in government securities at the end of 2004-05, well above the statutory SLR of 25 per cent. One reason why the sharp credit growth since then has been financed relatively smoothly is that, for the system as a whole, banks have hardly made any investments in G-Secs since then (around Rs 7,26,000 crore on both April 1, 2005 and June 9, 2006). The ratio has already dropped to around 30 per cent and, as deposit growth continues, banks will have to start making investments in government securities once again. Financing these investments plus the strong commercial demand is a tall order and the apprehensions of our editor, quoted at the beginning, are well founded "" this, despite the system currently having surplus funds and investments of the order of Rs 1,50,000 crore.

To my mind, there is only one way to square the circle: Parliament needs to pass the amendment to the Banking Regulation Act swiftly giving freedom to the central bank to fix the SLR ratio (freedom to drop CRR already exists). With the Fiscal Responsibility and Budget Management Act in place, the government's recourse to market borrowing as a percentage of nominal GDP, if not in absolute terms, should come down, and the SLR pre-emption could be reduced to provide funding for the commercial sector at reasonable interest rates. The central bank will then need to accept larger monetary growth than it has been used to, accept that with competition and globalisation, the inflation scenario has changed.

Tailpiece: Jaswant Singh has come out poorly in the issue of the supposed mole in the PMO. The claims made, and the backdown, are hardly signs of political sagacity or maturity. And to think that he was Vajpayee's most trusted ministerial colleague.

Email: avrco@vsnl.com