The
Reserve Bank is courting recession as it goes about combating
inflation by violating the basic requirements for economic
stability. By Prem Shankar Jha
There
is a spin being given to the latest increase in the cash
reserve ratio last week. It is that the Reserve bank had
no alternative because the commercial banks were drowning
in liquidity following the conversion of billions of dollars
on the capital account into rupees.
This
is utter nonsense. The problem that the RBI sought to
''solve'' by sucking Rs16,000 crore out of the banking system
was of its own creation, for the money was drawn to India
by the sharp increase in interest rates that followed
the first and second increases in the CRR in January and
April.
The
third increase in the CRR will only compound the damage
that the first two did, for it will firm up the prevailing
rates, and keep foreign money flowing into the Indian
market. The RBI tacitly conceded this on 7 August when
it chopped external commercial borrowing by large Indian
corporations to meet their rupee expenditures, off at
the knees.
The RBI continues to insist that it pushed up the CRR
and interest rates to contain inflation. But its action
has violated a basic theorem of international economics
formulated by two economists at the IMF in the 1950s.
In an open economy a country''s international account will
remain in equilibrium only when three conditions are met
the exchange rate is free to change in response
to changes in the demand for and supply of its currency,
capital is free to move in and out of the country, and
the prevailing interest rate is equal to the prevailing
rate of interest in the global financial markets after
factoring in the risk of borrowing.
Till July 2006, the government ''s management of the economy
was in line with this theorem. International equilibrium
was maintained through a small but steady depreciation
of the rupee in relation to the principal international
currencies that more or less compensated for a slightly
higher rate of inflation in India over the global average.
In July the rupee reversed course and began slowly to
appreciate. This was partly because of a rise in FDI and
inward remittances but mainly because of the depreciation
of the dollar. It was therefore entirely natural and required
no corrective action by the government.
But
the two successive increases in the cash reserve ratio
destroyed the equilibrium by pushing Indian lending rates
well above those in the international financial markets.
While the average real lending rate was 4.8 per cent (8.3
per cent nominal minus 3.5 percent inflation) in the OECD
countries earlier this year, and 5.3 per cent in the Gulf
Co-operation Council countries, it was 8.6 per cent by
the most conservative estimate in India (13 per cent PLR
minus 4.4 per cent inflation). In fact since inflation,
measured on a month-to-month basis virtually disappeared
after October 2006, the real rate of interest in India
rose close to 11 per cent.
Indian
businesses therefore decided to go abroad for loans. The
figures for external commercial borrowings speak for themselves.
In 2005 Indian firms borrowed a billion dollars abroad.
In 2006 this figure jumped to $13 billion. In January
to March this year it has doubled further to $2.1 billion
a month. Between April and June it went up further to
$ 3.3 billion a month! It was only then, long after the
horse had a bolted, that the RBI closed the barn doors.
The
bulk of the loans have been taken by a handful of very
large companies or groups Jet Airways, Kingfisher
Airlines, Air India, Indian Airlines, Tatas, Larsen and
Toubro, and a few others. But their borrowing has been
dwarfed by that of the two Reliance groups. Between April
2006 and March 2007, the last month for which detailed
information on borrowers is available, these raised a
total of $7.775 billion dollars abroad. This is just under
half of all the external commercial borrowing between
April 2006 and March 2007. The Reliance groups raised
more than a third of this in February and March 2007,
after the first increase in the CRR.
This
surge in private borrowing has combined with NRI deposits
seeking windfall gains from the appreciation of the rupee,
and short-term foreign investment in the share market,
to push up the reserves by $49 billion in 15 months. Of
this, $35 billion dollars flowed in between January and
June 2007.
The
Reserve Bank violated the basic requirements for economic
stability because it sought to bring down inflation the
easy way. But, as Thailand found out at East Asia''s cost
in 1997, this is a road to disaster. The similarities
between Thailand in 1996 and early 1997 and India exactly
ten years later are uncanny. The spike in inflation that
made the Thai central bank raise interest rates occurred
for precisely the same reason as India''s spike in inflation
last summer the effect of a poor monsoon on agriculture.
The core rate of inflation in Thailand remained unchanged
throughout the months before the crisis.
In
India, while inflation (according to the wholesale price
index) had increased from 3.5 per cent for the year on
22 April, 2006, to 5.7 per cent on 21 October. But three
per cent of this was accounted for by an increase in the
prices of primary products during the summer caused by
the weather and an increase in international oil prices.
The core rate of inflation ie the portion of the
rise in prices that monetary policy can curb was
a little under three per cent. India, in short, was not
suffering from any significant increase in internally
generated inflation when Mr Reddy brought the hammer down
on growth.
In
Thailand the increase in interest rates did not curb investment
by very much. All it did was to make investors borrow
abroad. Exactly the same thing is happening in India today.
The difference, a crucial one, is that the Baht was convertible
on the capital account, and the Thai government had made
a public fetish of maintaining the exchange rate at any
cost. Thai borrowers therefore faced no limits on their
borrowing, and took huge, unhedged, loans. By contrast,
Indian borrowers faced a ceiling of 22 billion a year
on total borrowing, and had to hedge their loans. However,
had the RBI not stopped borrowing to meet rupee expenses
this would have only slowed down the build up of debt
on the capital account and limit but not eliminate the
volatility of capital flows.
In
the meantime India is headed for a recession. Three major
banks have already sold Rs750 crore of bad housing loans
and more are likely to follow. Anticipating a glut of
apartments and houses on the market and fearful of the
high interest rates, builders have put new projects on
hold. This will cause the demand for cement and steel
to slacken.
There has been a 15 per cent drop in the sale of two-wheelers
in the first quarter, a smaller decline in the sale of
commercial vehicles and a massive shift from larger to
smaller cars in the ''non-executive'' class of automobiles.
Bank advances have shrunk by Rs33,000 crore almost entirely
in the non-food commercial sector. Most of this reflects
a fall in consumer credit.
The
BPO industry, which works on a 15per cent margin has seen
virtually its entire profit wiped out just when a shortage
of manpower is forcing it to raise salaries. Garment exporters
are in a panic and beginning to lay off workers because
new orders are scant.
Despite
all this, Mr. Chidambaram said in Bangalore that a 10-per
cent growth this year was, quite literally, unavoidable.
He should have remembered that he had made similar predictions
in 1996, but in November that year the rate of industrial
growth fell from 13.8 per cent the previous year to 3.5
per cent and stayed below five per cent for the next six
years.
|