For the past several months WPI inflation in India has been negative whereas CPI inflation has been hovering around the 5 to 6 per cent mark, notwithstanding the occasional spurt in prices of some food items. Yet, the Reserve Bank of India (RBI) policy rates are high leading to high real interest rates. The table below depicts implied values of real interest rates using current inflation figures and assuming that actual inflation equals expected inflation. Few, if any, major countri1es in the world have such high real interest rates.
Cost push factors associated with two successive failures of the South West monsoons and unseasonal winter rains in 2015 have played a major role in CPI inflation. It is a measure of the maturity of the Indian economy that such massive shocks have not derailed economic growth. Concurrently, the contribution of demand pull factors has been relatively modest, not the least because of sluggish rural incomes following from the prolonged drought. Globally, except for a small increase in the US rate interest rates and that too after years of zero interest rates and QE, the interest rates of most of India’s principal trading partners have been low and, in the case of Japan, recently become negative.
Targeting the repo rate to CPI inflation, as the RBI is currently doing (and committed to institutionalise), ignores the deleterious effects this policy is having on the manufacturing sector, apart from the fact that the impact of such targeting on inflation in India is subject to wide margins of error. With high costs of borrowing (corporates with access to foreign credit would, in the face of a relatively stable exchange rate, rather borrow from abroad where interest rates are low) and sluggish revenue because of WPI deflation, corporate profits are getting squeezed from both sides. Hence, private investment in general and, in the manufacturing sector in particular,are not as buoyant as would be presumed, given the broad improvement in policy outlook. With the ongoing squeeze in private investment, such a sanguine perception of the policy outlook need not persist indefinitely. The proclivity for private investment is slow to rise but is inherently fragile and can fail easily.
With investment below requirement, given any incremental capital-output ratio, economic growth, although higher than before, is below potential. With continued sluggishness in exports, the external sector is not able to provide a fillip to economic growth. Hence, some economists have advocated relaxing the fiscal deficit target and prescribed the wrong medicine of boosting public expenditure, even at the risk of raising the fiscal deficit, to boost growth. Such rise in the fiscal deficit would increase the chance of an interest rate hike as the RBI has already indicated. The recent budget has done well to assert its commitment to fiscal discipline.
Recently, the RBI has raised the issue of high NPAs in some banks and is signalling that higher fiscal deficit along with higher burden of NPAs constitute a recipe for incipient macroeconomic instability. This could then spill over into a number of other economic indicators including the exchange rate. Stabilization could then require a raising of the interest rate which would further lower the chances of growth revival, not to speak of additional burden of servicing the public debt and private NPAs. This policy may not exacerbate short-term instability but will certainly jeopardise the prospects of economic growth and, hence, medium-term macroeconomic stability. These are some of the stark challenges that the Indian economic policy making faces at the moment.
With competing goals and limited instruments it is always advisable to opt for ensuring that we follow the principles used to solve the assignment problem, i.e., have at least as many (relatively independent) instruments as policy objectives and assign any policy to the target on which it has maximal impact. In the present context, this would necessitate that lowering the NPAs should be directly entrusted to a policy of systematic loan recovery, particularly from the larger defaulters. This needs to be accompanied by a cutting of interest rates. This, by reducing the cost of investment, would also stimulate investment and output growth. The increased tax revenue would lower the fiscal deficit and indeed, in the face of better private sector net revenues, further increase the chances of recovering the NPAs.
Thus, there is a case for the RBI to revisit its monetary policy stance. Indeed it is high time.
The author is Professor and Head, Arndt-Corden Department of Economics,Australian National University.
Email: r.jha@anu.edu.au