The economy has begun to show distressing results because of low growth impacted by high interest rates, arguably justified because of high inflation and the global financial crisis. Stringent monetary measures have not been able to tame inflation - which has been high not because of demand but supply-side and political economy factors - but slowed the overall growth of the economy, resulting in rising stressed assets.
In a close precedence, though Paul Volcker was successful in taming inflation by significantly tightening the monetary policy in the US in the 1980s, it led to recessionary pressures. Still earlier, one of the reasons for the Great Depression of the 1930s was tight monetary policy, according to Anna Jacobson Schwartz and Milton Friedman. In India, which lacks a seamless monetary transmission mechanism and a social safety net, such stringent policy measures also need to consider demographic factors of the economy.
But first, some relevant facts from the latest Financial Stability Report (FSR) released by the Reserve Bank of India. The FSR observed that the global economy is shrouded in uncertainty, and tapering in the US could lead to repricing of certain assets, resulting in volatility in financial markets. Non-performing assets have increased significantly and so have the stressed assets, which can be expected because of the slowdown of the economy by more than half in less than three years.
Public sector banks are most affected by the slowdown in the economy. The sectors in which stressed assets are rising significantly are textiles, iron and steel, mining and aviation.
The infrastructure sector, which includes construction, is also recording high-stressed assets consequent to recent slowing down of the services sector. The latest data on the Manufacturing Purchasing Manager's Index (of HSBC), showing a decline from 51.3 in November to 50.7 in December 2013 implies that growth would remain moderate mainly due to structural constraints and high interest rates.
The slowdown in the economy is impacting government revenues and leading to high fiscal deficit and higher government borrowings, which in turn distort the financial markets.
The FSR rightly stresses that lower government borrowings can help in addressing structural constraints in abating financial market development. Again, high interest rates and uncertainty in the interest rate policy has resulted in high cash and bank balances of the corporations, which includes fixed deposits and lower fixed assets such as plant and machinery, as discussed in the latest FSR.
In India, in the arguments against inflation, the demographic aspect is constantly being neglected. In this context, there has been a constant flow of good research from Japan. Bank of Japan Governor Masaaki Shirakawa (May 2012), argues that the economic profession does not make a distinction between the quality of population in their models of economic growth. The expansion of the working age population along with free trade led to rapid growth in advanced countries but things are changing since 1990s. The behaviour of the ageing population is different from the young population, as is their productivity and consumption pattern, which impacts the current account, reflecting the savings-investment gap in the economy. The "spending wave" hypothesis is associated with young population and Masaaki refers to empirical studies correlating inflation with population growth rate in 24 advanced countries. James Bullard, president, along with other researchers from the Federal Reserve Bank of St Louis, finds that a young population generates high inflation and ageing population places downward pressure on inflation (September 2012). Ikeda and Saito (February 2012) using a dynamic general equilibrium model report that ageing lowers real interest rates in the economy, implying lowering of inflation. Finally, Kiyohiko Nishimura, deputy governor, Bank of Japan, argued that in Japan, the US, and some other countries, asset markets are correlated to the working age population, and that bubbles coincide with turning points in demographic trends (June 2011).
It was not without reason that Olivier Blanchard, Research Director of the International Monetary Fund, has been advising countries to raise their inflation targets, because targets that are too low impact employment and growth. India, which is unique given its young demographic status, should factor in the aspirations and consumption demand of the young population and focus on employment generation and growth, rather than low inflation rate, solely based on experiences of advanced countries.
The general argument is that retired pensioners would be severely impacted by inflation. But the pensioners from the organised sector get compensated by the adjustment in dearness allowance, while in the unorganised sector people continue to work even in advanced old age. Nevertheless, it needs to be examined, in a country with a young demographic trend, whether unemployment or inflation is a bigger concern. If given an appropriate opportunity, every citizen, born with two hands but one mouth would contribute to investment and growth, as Angus Deaton observes in his latest book, The Great Escape.
It is not being argued that inflation should not be under control but such stringent measures that lower growth rates, increase financial vulnerabilities, erode public confidence in reforms and impact international ratings may not be judged kindly by history.
The author is RBI Chair Professor of Economics, IIM Bangalore.
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