With the drop in the wholesale price index, there is once again renewed speculation as to whether the Reserve Bank of India will lower interest rates. The RBI feels it needs to wait and see whether the decline is sustained, and also whether the consumer price index tracks the WPI.
But whether the RBI sits tight or reacts quite frankly does not really matter that much to getting growth back - or even lowering inflation. In India, as in the rest of the world, there is excessive focus on the role of monetary policy and the actions of central banks in reviving growth and reducing unemployment. The real solutions lie elsewhere - mostly in fiscal and structural and sectoral policies.
This excessive focus on monetary policy and the role of central banks not only distracts but - as in the case of the United States', and now the Japanese and European central banks' actions - is creating a flood of global liquidity that is very harmful to the global economy, and asset bubbles which when burst create a huge backlash. India and the world need to get away from this fixation with the role of the central bank.
Monetary policy does have an important short-term role in averting crisis - as we saw globally and in India when the global economic crisis struck in 2008. But looser money cannot substitute for the serious structural reforms on labour markets, land use and infrastructure development that is needed to restore competitiveness and boost economic growth. Likewise, tighter monetary policy cannot help control inflation when the source of inflation lies in supply side policies and fiscal deficits. The RBI did a great job a year ago to restore credibility to the rupee after it had overshot on news of tapering. It has since rightly built up reserves to bolster India's balance sheet against future volatility. But its role in economic revival remains limited and supportive at best.
Globally we have seen aggressive use of monetary policy over the last five years to revive growth and reduce unemployment. Quantitative easing - an extreme form of monetary policy, when the central bank buys assets to inject greater liquidity into the economy after interest rates have dropped to zero and cannot be reduced further - was first introduced in 2001 in Japan after a decade of low growth. But after a four-year QE programme, the effects on the economy were minimal if anything; even the Bank of Japan admitted to its limited impact on the real economy.
In the US, the first phase of quantitative easing - QE1 - initiated by Ben Bernanke helped stem the crisis after the collapse of Lehman Brothers in 2008; but the benefits of subsequent quantitative easing, QE2, in 2010 in terms of restoring growth and reducing unemployment are questionable. Even greater doubts have been expressed over QE3, introduced in September 2012, especially as much of the excess liquidity helped create asset bubbles globally and complicate macroeconomic management for emerging economies. Economic recovery in the US has done better than in Europe and Japan, but remains weak. And some feel easy money has given an excuse to avoid tougher structural reforms.
As the US Federal started "tapering" QE - slowly reducing its size, and eventually that of its balance sheet - the pull-back of liquidity from emerging economies created huge macroeconomic dislocation. With hindsight, QE2 and QE3 were excessive and misguided, and now their pullback creates its own problems.
The European Central Bank started a smaller QE programme in 2009, but now Mario Draghi has enlarged it - despite clear evidence that Europe's problems are structural and policy-induced. The straitjacket of the single currency also removes an important instrument for economic adjustment - exchange rate policy. And Japan, despite an earlier bout of failed QE policy has under Prime Minister Shinzo Abe aggressively used monetary policy to avoid deflation. But, without implementing the tough structural reforms which were part of the Abenomics package, the impact of monetary policy would like elsewhere not be beneficial for growth. It risks creating huge asset bubbles.
China's experience shows that monetary policy can be supportive if growth and macroeconomic management is based on structural and sectoral reforms and tight fiscal policy. China has not only recovered well from the global economic crisis but has sustained growth and low inflation subsequently, despite facing the same global pressures as India. If anything, China was more adversely affected by the global crisis given its larger trade share; but its large reserves helped buffer it from exchange rate volatility. China has used monetary policy to modulate credit activity, but not as a substitute for genuine real sector policies and factor market reforms.
In India too we see our own excessive focus on the role of monetary policy when its impact on medium-term growth and inflation is marginal. In India, given the lower level of monetisation the role of monetary policy is even weaker than in the more monetised developed economies. The recent evidence of a small uptick in growth and decline in inflation is due to base effects and administrative actions - the easing of food stocks, and faster and more coordinated decision making in government on mining and infrastructure. If these sectoral actions are maintained with tighter fiscal policy, we could see growth above six per cent and inflation below six per cent by the fourth quarter of the 2014-15 fiscal year.
India needs now to focus on genuine structural reforms: get the goods and services Act moving; build consensus on labour market reforms; ease land acquisition; supply more infrastructure; and above all reduce red tape. We hope the 2015-16 Budget will see some serious moves on these fronts. A slight movement up and down on the interest rate, which gets so much attention from everyone, is not what will really affect the growth and inflation trajectory. Let us put the spotlight back to real-side and fiscal policies.
The writer headed the Independent Evaluation Office of the Union government
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
