The RBI focuses on WPI and so outside experts like the IMF who think other indices are more reliable turn around and say Indian inflation is high, says Surjit S Bhalla
When asked whether the $ 700 billion dollar package to save US banks, and the US economy, would do the trick, Fed Chairman Ben Bernanke replied “I don’t know; and I have been wrong recently”. This kind of an admission, in front of millions, can only come from a secure and first rate mind. It is time that policy makers in India also learn to practice a little humility — and learn from their mistakes for the sake of themselves, and the Indian economy.
The credit crisis has made geniuses out of most commentators. Oh, there is a liquidity crunch and therefore what needs to be done is to provide liquidity. What about the high level of interest rates in India, should we also not be reducing them, and reducing them drastically? You’ve got to be joking, is the refrain of the experts. With credit growth at 24 per cent and money supply growth at 19 per cent, and inflation at 12 per cent, how can you cut rates? Are you not going to cause even more inflation, cry out the we-know-what-to -do-about- the-crisis experts? So how come there is a liquidity crunch if credit growth is so high? That falls on deaf ears, because the mind of the experts is made up — and made up by the RBI. And then when you ask the RBI as to whether it has made a mistake, the refrain is why don’t you look at what the non-RBI experts are saying — don’t you see, they all agree we are doing the right thing. The vicious circle continues and the forces of globalisation hide the mistakes when the going is good — which was until last year.
In this two-part article about monetary policy making in India I want to comment on what has been wrong about monetary policy in India, and what can be done to put policy, and India, on the path towards stable growth and low inflation. First, and most importantly, RBI policy in India since 1991 has been of the rear-view window type — that is, backward-looking, and reactive. [There is an important exception to this which occurred during the Bimal Jalan period as Governor in 1998-2003, but that is a subject of another article. Given this exception, I will term RBI policy as the Rangarajan-Reddy or RR policy]. Monetary policy, by definition, has to be forward-looking, and even then, as events in the US have shown — the US Fed started anticipating the crisis as early as August of 2007 — the policy need not be successful. But a backward-looking policy almost guarantees failure, in addition to being not very enlightened. Second, RR policy has used the wrong indicators on both the inputs to policy and the outputs ie both on what the policy should be (money supply growth) and what indicator should be used to assess the impact of policy (inflation as measured by the wholesale price index or WPI). This RR policy then feeds into the expectations of the analysts of the Indian economy, who then regurgitate the RR analysis, and mistakes.
All experts and policy makers face the problem of “identification” in making assessments: how does one know that some unknown other cause is not causing the mistakes that are being ascribed to RR? In an absolute sense, one doesn’t but there are identifying factors. And such factors are two — first, the same expert when assigned to work on a different country (and this is not a virtual expert, but rather your friendly IMF, World Bank, or pink newspaper, or investment bank representative scholar) will not use either money supply growth or WPI inflation to assess monetary policy! The second identifier is what has happened to the Indian economy prior to the world wide liquidity crisis that started in September. Since August all bets are off regarding the causes of failure of the Indian economy, but that certainly is not the case for before August. Especially if one considers the last Reddy policy of increasing interest rates and the CRR on July 29; he even argued on September 7 that if he had had his way, he would have tightened monetary policy even more!
The only other central bank governor making the same noises, and wrong policy, was Jean-Claude Trichet of the European Central Bank (ECB). He also raised rates in July and just two weeks ago claimed that the financial crisis was an exclusive American problem and that the crisis revealed both how bad American regulatory system was and how good the European central bank was. A week after this unseemly gloating based on fictitious facts, Jean-Claude Trichet admitted that the ECB had “under-estimated” the crisis. A few days later, the ECB had to intervene to save European banks; and a few days later, Europe announced a larger than American package to save European banks! When will Indian policy makers admit that they over-estimated the strength of the Indian economy, or the non-fragility of their own banking system?
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On money supply or credit growth as a primary indicator of policy direction: There is a reason why most central banks in the world do not use these two indicators as “information” — the data are very noisy and most importantly fail to provide any statistical confidence. The table shows the pattern of money supply growth etc for the last 60 years. What is noteworthy is the constancy in money supply growth, the favorite policy indicator of the RBI, at 17 per cent since the 1970s, ie for the last 40 years. During this period, the world has changed, oil prices have gone up 10 to 20 times, India’s GDP growth has accelerated from 4 per cent to 9 per cent, and inflation has collapsed from 8 to 9 per cent to an average of 4 to 5 per cent. The government, and RBI, and RR should now ask — of what use is this indicator, and why has it been misleading itself, and the economy?
But the RR policy has been doubly flawed because of the emphasis on WPI inflation as an indicator of inflation. The circle of error goes as follows. RBI has made it clear to the world, and anybody watching, that it is looking at WPI inflation, and also year-on-year (yoy) WPI inflation. As even the RBI knows, yoy inflation includes all the inflation that has happened for the last 12 months. In that sense, to follow yoy inflation is backward-looking policy at its worst. Even worse is the fact that the RBI does not recognise that “outside” experts look at this error and extrapolate. How else can you explain the fact that even as prestigious a set of analysts as those at the IMF will look at India’s monetary policy and say that it has been too loose over the last year? If one looks at the latest IMF World Economic Outlook (WEO), the inflation rate for India for 2008 is forecast to be 5.3 per cent for the CPI and (what is likely an error) only 3.8 per cent for the GDP deflator! The WEO does not supply any data on money supply growth, or WPI, for any country in the world, though it does supply data on the GDP deflator and CPI. So why does the IMF use the WPI data to determine its policy conclusion that Indian monetary policy was too loose? Accountability, anyone?
The author is Chairman Oxus Investments, a New Delhi-based asset management company. The views are personal