Subir Roy: Not the best medicine

VALUE FOR MONEY

A visit to the doctor was necessary but it is not at all clear that the strong dose of antibiotics that he prescribed is needed and whether it will ultimately do more good than harm. Inflation remains at 6 per cent plus, higher than acceptable, and money supply growth remains at 29 per cent, a good 5 percentage points more than what is considered safe. However, the rationale for the sharp action that the Reserve Bank has taken, raising both the repo and CRR rates, must rest not on the past but expectations about the immediate future.

It is here that perceptions differ. Those supporting the move say that banks were simply not listening to the regulator and merrily expanding credit and competitively raising deposit rates to almost a ten-year high. So a strong signal was called for. But the other view is that the RBI panicked when there was no reason to do so.

There is no overheating in the economy and supply constraints are emerging only in cement and steel. The latter can be taken care of by reducing the landed cost of imports. This may not work because a global rise in prices is forecast for the immediate future. But there are two opinions on even this. If Chinese exports keep galloping the way they are doing despite their government's avowed objective of reducing exports, any global shortage and price rise can only be temporary.

The strongest argument of those who say the RBI should not have panicked is that the worst of the inflationary impetus is over. The two bubbles, in stocks and real estate prices, have lost their fervour and, what is most important, a good rabi crop is expected. This should take care of the upward pressure on cereal prices, a key element in the current inflationary cycle. Plus, a good crop dampens prices all round.

The RBI's critics further add that to get the better of inflation, when asset bubbles are already deflating, it is necessary to desegregate the inflationary pressure and act selectively. The current inflationary pressure is limited to food and commodity prices. (Oil prices remain the wild card but countering fluctuations in them, mostly politically engendered, is not part of conventional demand supply analysis.) The former won't come down by making food dearer via all round dearer money. It will only spread distress as food consumption will take up a larger part of the poor's household expenditure. As the scope for food imports to ease supply side constraints is limited, the only way out is to improve agricultural output. If shielding the poor from rising food prices is the policy goal, then it will be best served by raising subsidy and targeting it better.

The other component of inflation""global commodity prices""is also likely to abate in the current year. According to one forecast, these prices are likely to go up by just over 2 per cent in 2007, compared to over 31 per cent last year. Weren't we saying the worst is over? What is more, if strong hard commodity (metals, etc) prices remain an issue, there is an admirable instrument to tackle it""by lowering import duties.

The last, in fact, is a significant weapon which in the current context seems far more preferable than monetary tightening. A key culprit in creating inflationary pressure is the mopping up of dollars, which the RBI is doing so as not to let the rupee appreciate further, as evidenced by the rise in reserves. Since capital inflow does not appear to be easing, the best possible counter measure will be to let the rupee float upwards gradually. This will not only dampen the landed cost of imported commodities but also lower the appetite (more rupees for the same dollar) of banks and companies for overseas capital. The RBI is currently in the absurd position of raising the differential between domestic and overseas interest rates and thus encouraging foreign inflow when precisely the opposite is needed to curb demand.

The RBI governor has correctly stated that India's tolerance level for inflation is low. But to that a rider needs to be added. There is a fear of return to the slowdown of the mid-nineties prompted by harsh tight money policies. One of the key components of the emerging Indian competitiveness has been the falling cost of funds. Right now, small and medium businesses which cannot borrow abroad or bargain with banks are getting ready to pay 13 per cent. This is dangerous. Also the economic expansion of the last few years was fuelled by demand for home electronics, motorcycles and cars through falling rates of consumer credit. Motorcycle sales rose exceptionally over the last year (2006-07) but the growth rate was sharply stanched in March because of dearer credit.

Perhaps the most sensitive to interest costs is the demand for housing loans. Interest for these has now crossed 11 per cent. It makes abundant sense to cut off bank finance to real estate developers but hardly to individual home loan seekers, particularly for those not out to acquire a second property. The case for not raising home loan rates is even stronger when we recognsie that property prices have peaked and are currently coming down across the country.

Important as it is to rein in current demand, it is critical to ensure that investment in infrastructure not only does not suffer but is stepped up. Without that future growth will be stymied and inflationary pressure will rise as capacities get stretched. In fact, a case can be made for sharply hiking investment in roads, ports and railways by taking a calculated gamble on short-term inflation. China has had a history of massive investment in infrastructure and periods of high inflation. What is needed is to go about it in a planned manner and prepare expectations so that the markets do not get an unexpected jolt.

sub@business-standard.com