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Monetary stability at what cost?news
30 December 2006

Prem Shankar JhaThe year that is ending has seen the fastest growth India has ever recorded. Although it has not yet ended, the Central Statistical office has estimated a growth of 8.7 per cent. In fact growth could even touch 9 per cent. Were that to happen, the average rate of growth for the past four years will touch an all-time high of 8.3 per cent.

But 2007 may see the spurt come to an end. The reason, if this were to happen, will not be anything intrinsic to the economy, but just an excess of caution on the part of India's main money manager, the Reserve Bank of India.

For more than a year the Reserve Bank and the central government have been pulling in opposite directions: while Mr Chidambaram, Dr Ahluwalia, and the prime minister have been tirelessly emphasising the need to maintain, and if possible further raise, the already high rate of growth, the governor of the Reserve Bank, Dr Y V Reddy, has been warning the nation against the threat of inflation and pushing up the rate of interest to moderate it.

Since October last year he has been tightening the money market in small doses by raising the cost of inter bank transactions such as the repo and reverse repo rates. On December 8, he went a long way further and announced a half per cent increase in the Cash Reserve Ratio to take effect in two tranches on December 23 and January 6. These increases, it is estimated, will take Rs13,500 crore out of the banking system

Dr Reddy's reasons for doing this are easy to grasp: Money supply has grown by 18.7 percent in the past year. After deducting the anticipated 8.7 per cent growth of GDP this year there would be a ten per cent gap that could fuel inflation. In the past half century that gap has almost never been filled by the actual rise in prices, but it is still uncomfortably wide. The fact that the index of wholesale prices has risen by 5.9 per cent since March, and that on this occasion, manufactured products have contributed a sizable amount to the increase (4.9 per cent since March against 3.1 per cent last year) has clearly sharpened the RBI's fear that the rate of inflation could mount in the next few months.

Despite these signals one cannot but agree with the finance minister, Mr Chidambaram, that it is premature to conclude that the economy is overheating. It is true that the consumer price has risen by 7.3 per cent during the past year. But fully 2.5 per cent of this has been caused by a rise in the price of agricultural products, since March. The 4.9 per cent increase in the wholesale price of manufactures is not significantly different from the increase that took place in 2005. In other words, the 'core' rate of inflation, which can be controlled through monetary policy, has not risen sufficiently to cause alarm.

This leaves us with two questions: What can a tightening of money supply do to fight against the vagaries of nature, and how much inflation should an economy be prepared to tolerate in order to avail itself fully of the benefits of high growth?

The answer to the first question is obvious: Nothing!

The only purpose of raising interest rates in the face of a shortfall in supplies is to prevent speculative hoarding. This is the reason why economists of my vintage used to cry ourselves hoarse in the '60s begging the government not to rely on physical controls alone but to raise interest rates when the monsoons failed. That era of administered, habitually negative, rates of interest is long gone.

As for the second, there can be very little doubt that Dr Reddy's caution is likely to extract a disproportionate price from the economy. After staying between in single, sometimes low single, digits for more than nine years, it is only in the last seven months that the rate of industrial growth has gone above ten percent. Between April and September the index of industrial production grew by 10.9 per cent and that of manufacturing by 11.9 per cent.

But the past string of money tightening measures were already taking their toll even before the rise in the CRR. Lending rates had risen sharply in the market. So much so that mortgage rates on new housing loans, which used to be 8 per cent two years ago, have now climbed to 10.5 per cent. This has already taken its toll: in October industrial growth dipped sharply to 6.2 per cent, almost entirely because of a complete flattening out in the sale of consumer durables. The increase in the CRR is almost certain to push up interest rates further. This could kill the hosing boom, and keep growth in the consumer durables sector down in the coming months.

The increase could also nip the investment boom in the bud. The core sector has seen an 80 per cent increase in orders in the past year. According to a recent survey by the Centre for Monitoring the Indian Economy (CMIE) 1,158 new investment projects have been taken up in August, September and October. If interest rates rise sharply and share prices dip, one can only wonder how many of these projects will be 'postponed' as has happened so often in the past.

The costs that an excess of caution can impose upon the economy go much deeper. The last two years have seen not only a spurt in growth but also in employment. Proof of this, imperfect though it is, lies in the decline by two million of job seekers on the 'live register' of employment exchanges - the first of its kind in our history. The spurt in growth has also led to a 33.9 per cent increase in tax revenues between April and October, substantially higher than in the previous year. A few more years of such sustained growth could wipe out the revenue deficit altogether.

Finally, it is worth bearing in mind that a rise in inflation that results from a spurt in productive investment is completely different from a rise caused by a decline in saving and increase in consumption. The former is temporary and will ease as soon as the investment is completed and is brought on line. It is only the latter that needs to be discouraged. An increase in interest rates that discourages production and investment only perpetuates the shortages that caused the inflationary pressures to surface in the first place.

The Reserve Bank's excess caution stems from a regrettable penchant among Indian economists for following the currently popular prescriptions of policymakers in the industrialised countries.

Somewhere in the late '70s the goal of the rich countries was to eliminate trade cycles instead of smoothing them out through contra-cyclical spending during the recessionary phase. This made sense because once globalisation set in, because whenever governments tried to increase public spending to revive demand, it only led to an increase in imports from low-wage countries like Korea or Taiwan.

But in our case we need huge and prolonged booms to create the assets we need for the future, and to generate employment. Our correct policy should be to let the current boom go on, with only minor adjustments of the interest rate to compensate for inflation and ensure a stable real cost of borrowing, and rely on contra-cyclical spending to keep up domestic demand when the boom shows signs of petering out.

China did that after 1997 and has created an infrastructure network in less than ten years that is the envy of the industrialised world.

* 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

also see : Other articles by Prem Shankar Jha

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Monetary stability at what cost?