I was obviously wrong when I suggested in my last column that it would be difficult for the new government to do badly in its economic performance. The economy the new government has inherited is well established on a medium trend of 7 per cent growth, with a reasonably high rate of savings and productivity of capital, and also with a high potential for agricultural and industrial growth. All the new government would need to do is to correct the mistake of the previous government of repressing the economy through contractionary monetary and fiscal policy, to reduce the interest rates and to raise public investment, which would stimulate growth and bring the economy back on its trend. As the marginal rate of savings is higher than the average, the incremental savings of the people from the incremental income would exceed the current rate of savings as a proportion of income. As a result, the availability of domestic savings will increase with the growth of income. This, together with increased inflow of
foreign savings, attracted by the prospects of a growing economy, will be able to finance a higher rate of investment without inflation, which in turn will raise the growth rate even further. The economy is poised to respond to policies that stimulate growth, making it at least feasible for everyone to live more happily hereafter.
The statement of the Prime Minister at the CII meet and the speeches of the finance minister at different fora in India and abroad showed that the new government is all set to follow such growth stimulating policies. That created an environment of optimism for trade and industry, domestic and foreign investors. The first shot at puncturing that optimism came from the recently announced RBI credit policy. It reflects the typical bane of a coalition government everyone trying to protect his turf and building up his image with total disregard for what happens to the system as a whole. This is debilitating in politics, but can be disastrous in economics.
The RBI has protected its turf completely. It has not relaxed its monetary policy. It has not provided the banks with any additional liquidity by lowering the CRR. The 1 per cent cut in the bank rate is only notional, as it is rarely used. The export credit rate has been restored to the January level, which was, even then, very high, compared to what is needed to make exports competitive. Annou-ncing a low target of broad money growth, it has signalled that the squeeze on liquidity will continue. The rate of inflation is now quite low in India, and the RBI would like it to go down even further.
There is no let up in the interest rates policy either. Earlier, the RBI was following a policy of increasing liquidity of the banks by reducing CRR. That should have expanded the supply of credit to the commercial sector and reduced the interest rates to create the demand. The policy was not very successful, as banks did not increase lending to avoid risky business, and did not mind being left with excess liquidity or holding risk-free government papers even at low rates. The policy has done little to change the position. On the contrary, the yields on the government papers are going up, making them more attractive to hold, reducing further the incentives to look for other business.
In fact, three days before the new credit policy was announced, the RBI accommodated an eight-year government security at 11.75 per cent for Rs 5,000 crore. This should increase the RBIs profits at the expense of the government, which usually borrowed from it against low-interest adhocs. But it also signals a possible floor to the interest rates, because sooner or later it is most likely that the RBI would off-load these securities in the market. In any case, the massive borrowing programme of the government will keep up the pressures on the interest rates. If a bank can hold risk-free government paper at around 12 per cent, why should it chase private borrowers with all the risks at 14 per cent? It is highly unlikely that there would be much reduction in the average interest rates or much expansion of credit supply to the commercial sector, even if notionally the declared prime lending rates for best customers come down to 13 per cent.
The RBI has followed the conventional path of the central banks with a tight money policy, and with inflation control as the primary goal of that policy. Fed follows that policy, as does the Bundesbank and, recently, the Bank of England. Their chairmen get all the kudos from the financial world, with their names shining in the annual issues of Euromoney.We should be legitimately proud if our governor also figures in the list of great bankers. But what about giving a kick-start to our own growth process? How to get out of the recession when all the basic indicators for the medium term show that we should grow at no less than 7 per cent? How to revive the rate of private investment which grew at 17 per cent a year during the last three years of the Eighth Plan? Does monetary policy play no role in that? Does interest rate not matter at all? Would the world fall apart if the inflation rate climbed up to 7 per cent rather than 5 per cent? Shouldnt monetary policy do something to stimulate exports, either through export credit or exchange rates? Is a marginal relaxation of the ceiling on bank lending against dematerialised shares sufficient to promote the stockmarkets?
It is easy to shrug off all these questions by saying that these should have been taken care of in the budget. Fiscal policy should fix things which monetary policy is not supposed to do. But our poor finance minister is caught in a trap. If he alone has to kick-start the economy, he will have to raise public investment and also public consumption, to remove infrastructure bottlenecks and to increase effective demand. Where will he get the money? If he raises the tax rates, everyone will shout, especially after Mr Chidambaram has set the precedent of tax bonanzas. However much he improves the tax administration, he can hardly get a large amount in one year. He cannot reduce food or fertiliser subsidies, as nobody has been bold enough to do that. Pay Commission awards are now going to be extended first to teachers, then to others. And our new government, unlike Manmohan Singh and P Chidambaram, cannot allow by any means a cut in our defence expenditures.
Our finance minister has no alternative but to raise the fiscal deficit if he wants to stimulate growth only through fiscal policy. The RBIs high rates on privately placed government securities have signalled that this is now going to be very expensive. The central bank is telling the budgetary authorities that it will charge a penal rate even for money creation. This is in addition to the beating the budgetary authorities will get for fiscal profligacy from the IMF, the World Bank, the international financial community and the media. I doubt it very much that he can ignore all this. As a result, he will first try to cut current expenditures and subsidies. When he finds that this would be too much to sell to his colleagues, he will cut public investment and social expenditure. We shall then be back to square one. We shall have neither a rise in growth nor an improvement of social development.
