Monetary authorities should not practise ideology, especially since monetarist ideology has been made obsolete by globalisation and development.
In today’s world, some monetary officials want to play Volcker, where Volcker is synonymous (and rightly so) with intelligent monetary policy. While we do not know what Mr Volcker will do in today’s circumstances, we have several experts opining that the world today is similar to the 1970s and that therefore the correct policy response is to tighten monetary policy a la Volcker. Leading contenders for the “I am Volcker” prize are Mr Trichet of the European Central Bank and Mr Reddy, governor of the Reserve Bank of India. In my view, these two strict monetarists have completely misread both the current situation, and the situation that confronted the world, and Mr Volcker, in the late 1970s. It is also worthwhile to recall that Mr Volcker was no monetarist, and indeed, the governor most likely to win the most like Volcker prize is the nemesis of the monetarists, Mr Bernanke.
That is in the way of a forecast; let us examine why Mr Reddy’s policies are most likely to be wildly off the mark. With the CPI inflation rate around 7 per cent, Reddy increased the repo rate to 9 per cent, besides also increasing the credit reserve ratio (money deposited by banks with the RBI for which they receive zero interest!) by 25 basis points. Given the consumer price inflation rate of 7.5 per cent, this implies a real interest rate of 1.5 per cent. This move was welcomed by the economists of almost all foreign investment banks. Surely this high approval rating suggests that Mr Reddy is wildly on, rather than wildly off. Possible, but not probable. Investment bank representatives are like members of lobbying bodies like the CII and Ficci. Every year, regardless of the quality of the national budget, the lobbyists applaud the Finance Minister. The approval rating — between 8 and 10. Why? Because even today, Indian industry is beholden, or feels beholden, to the Finance Ministry for any largesse that it can provide. So if industry feels pressured to say something positive, one can imagine what the mere mortals at investment banks must go through. The bottom line: Don’t take the comments of foreign, or domestic, investment banks on the RBI seriously.
So how can one assess what the RBI is doing? In a few months, and years, the assessment will be easy. But this luxury only the historians can afford. For the moment, two methods of evaluation are possible. A comparison of the RBI’s policies with its own comments and interpretation of the present; and second, a comparison of the RBI with what other central bankers are doing, especially officials of fast-growing economies like India.
Two explicit statements of Reddy reflect his views. India has been overheating at least since April 2005 and, second, a surefire way to correct this overheating is to control money supply growth. This growth has been a few percentage points above the RBI mantra constant of 17 per cent. When the RBI sounded the first alarm bells of overheating (in 2005), unknown to the RBI, and the rest of us, was the fact that the investment rate in India had registered 32 per cent of GDP, and the savings rate was 31 per cent. Both these important macro parameters had already increased by 8 percentage points since 2000. If India indeed started overheating in 2005, then, in subsequent years, two effects should have been observed — a higher inflation rate, due to excess demand, and/or a stable, if not lower, rate of investment and savings. On both counts, the RBI assessment was off — the investment and savings rates continued to substantially increase, and inflation remained stable (according to the WPI, the rate declined; stable according to the GDP deflator, and the CPI registered an increase in the inflation rate of 1.5 percentage points).
The RBI still thinks in overheating terms because for it there is only one variable — the rate of growth of money supply. For something held so sacred, it is strange to find that the monetarist model (i.e. inflation is a function of the rate of growth of output and the rate of growth of money supply) finds little, actually zero, analytical support from Indian data. To be sure, there are some quasi research papers that relate the levels, rather than the rate of growth, of these variables. But estimating relationships between levels is akin to stating that the number of TVs causes mental illness — both go up steadily over time.
Maybe the RBI is just doing what officials of other fast-growing economies are doing. This won’t necessarily make the actions right, but it would mean that the RBI is following the global herd — and we all know that nobody can hold you responsible if you follow the crowd. (But then you can’t be a Volcker, either!). China has stopped raising rates and settled at a negative real rate of around -3.5 per cent. Korea just raised rates by 25 basis points, but to a level of -0.75 per cent real rate. Thus, Indian firms face a cost of capital some 2 to 5 percentage points higher than its competitors. Both New Zealand and the Czech Republic have lowered rates by 25 basis points each. Both cited the fact that the inflation is global, probably conjectured (different than the RBI) that $150/barrel oil should not be the reference price for monetary policy, and therefore cut rates to provide for inclusive growth to its citizens.
Inclusive growth is not a throwaway concept, though for the RBI (and the government?) it probably is. At least as indicated by their actions. The fat cats in industry are able to obtain credit from the international market at considerably cheaper rates than those mandated by the RBI. It is the middle classes, and the poor, who suffer from the high real cost of credit. And especially when this domestic high cost of credit does precious little to affect the international price of oil and commodities. These prices will determine the future course of Indian inflation, which most emphatically will not be affected by the sledge hammer RBI monetary policy. Unfortunately, the RBI’s policies can negatively affect GDP growth. Pain with no gain is what we have with the RBI.
The author is Chairman, Oxus Investments, a New Delhi-based asset management company. The views expressed are personal.