In its misplaced zeal to kill inflation at any cost, the RBI may soon find that it has killed a lot else, says distinguished columnist Prem Shankar Jha.*
The Congress party's inability to learn from its own past experience defies understanding. Step by inexorable step, it is going down precisely the road it took in 1995, and step by step it is heading for the same dire outcome.
In December 1994, the party lost the state elections in Andhra and Karanataka, and set up two committees to understand why it should have lost in these supposedly safe states. One of them reported that the cause was inflation, which had been high ever since the 1991 foreign exchange crisis and was being pushed up once more by the boom in the economy.
So in May-June 1995, with less than a year left for the next election, the party decided that this had to be brought down at virtually any cost. The belt tightening that began then killed the boom in investment of the previous five years and with that killed industrial growth. From 16 per cent in January-March 1996, it fell to zero in October 2000.
I have been warning readers in these columns that an exclusive reliance upon monetary policy to contain the boom that has set in will have exactly the same effect. (See: Monetary stability at what cost?) and also (See: Boom or recession: who decides?)
But my warnings have fallen on deaf ears. For politics has stepped in once again. After the Congress party's electoral defeats in Uttarakhand, Punjab and Manipur, the Congress has begun to look for explanations with the same frantic stupidity that it displayed in 1995.
Mrs. Sonia Gandhi has pronounced that the culprit is inflation once again. As a result killing inflation has been abruptly moved to the top of the agenda, and the burden has fallen once again entirely on monetary policy.
What no one has explained to Mrs. Gandhi is precisely how using monetary policy to kill inflation will end by killing growth. When it does that, the Congress will lose its sole selling point with the public so far, that in the past three years very high growth has made sure that no one who comes into the job market is denied employment.
If the recession that I now foresee develops - it will take between ten months to 14 months to fully reveal itself - by the time the Congress goes to the next election it will have next to nothing to show for its five years in office at least nothing that the ordinary people understand or care about.
Unfortunately we are so far down this road that it may be next to impossible to turn back.
Mr Y V Reddy, the governor of the Reserve Bank has been fighting a battle against the finance minister to give inflation precedence over growth for the last eight months. On Friday last week, he succeeded. After Mrs. Gandhi's pronouncement, the finance ministry caved in. So, instead of taking a close look at the most recent price and investment trends in the economy, Mr Reddy has pushed up the cash reserve ratio - the proportion of their deposits that banks have to hold in cash, by a full half per cent. (See: RBI steps up fight on inflation with Repo, CRR hikes) This is the third successive increase in the CRR in the past few months. Together they have sucked Rs43,000 crore out of the base of the financial system. The result has been predictable. Even before last Friday's increase three- to five-year deposit rates had crossed the ten per cent mark - 4.5 per cent higher than they were just six months ago.
Long term lending rates to blue chip infrastructure funds were close to 12 per cent. Fixed housing mortgage rates were 11 per cent or higher, again three per cent above where they had been in the middle of 2006.
Earlier last week, a sudden demand for rupees by companies selling dollars rather than raise loans in the Indian money market made call money rates jump momentarily to 60 per cent. Cursed as I am with a long memory, for me this was a nightmare revisited.
The impact on real estate is already visible - a 10 to 15 per cent drop in prices in Mumbai and Gurgaon is on the cards. Infrastructure companies are keeping their fingers crossed that the inflation rate does not rise, for if it does, they will be forced to postpone investment too. It is only a matter of time before industrial investment starts being 'postponed also' After that Mr. Hicks' trade cycle will kick in and drag us down to the nadir of October 2000.
Mr. Reddy, your last increase in the CRR was definitely a mistake. It is true that the economy had been overheating all of 2006-2007. Credit was increasing 50 per cent faster than deposits; oil prices were skyrocketing throughout the previous year, and a combination of home and export demand was pushing up the prices of key intermediates like steel and cement. You began, correctly in retrospect, to apply the brakes through Repo rates as far back as October 2005. But throughout 2006-07 the boom kept developing, and to make matters worse we found ourselves with a sudden shortage of primary products.
Speculators seem to have caught on to this before the government, for after five years of staying at Rs14,000 crore to Rs15,000 crore, bank advances against sensitive (agricultural) commodities suddenly shot up by 30 per cent last year. Not surprisingly, the WPI for manufactured products rose by 6.5 per cent and that for primary products by a whopping 17.2 per cent. Hence your first two increases in the CRR. And further tightening of repo rates.
But even if your use of these instruments was justified in January and February, by your own yardsticks it is not justified now. For in the past month, ie till march 30, the prices of primary articles had declined by 0.7 per cent, and those of manufactured products risen by 0.5 per cent. Even the latter was a result of premeditated increases in the prices of steel and cement that were timed to coincide with the budget.
You should therefore have waited for the next quarterly review before deciding whether or not to tighten credit further. You should have, above all, seen that if companies are prepared to sell their dollars to raise cash to complete projects then they already feel interest rates are too high. But in an excess of zeal you have used the hammer of monetary policy to kill an ant that was already halfway to death. You may end with killing a lot else besides.
* The author, a noted analyst and commentator, is a former editor of the Hindustan Times, The Economic Times and The Financial Express, and a former information adviser to the prime minister of India. He is the author of several books including, The Perilous Road to the Market: The Political Economy of Reform in Russia, India and China, and Kashmir 1947: The Origins of a Dispute, and a regular columnist with several leading publications.
(The author's articles can be read at www.premshankarjha.com)