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| RBI policies may be hurting Modi’s development agenda |
Indian factories are confronting the fact that people are not able to spend. The GDP for 2014 is expected to remain at 5.5%. |
 |  RBI Governor Raghuram Rajan addresses the media as Deputy Governor S.S. Mundra, Harun R. Khan and Urijit Patel look on during a press conference in Kolkata on Thursday. PTI he Narendra Modi government started out amidst big expectations of an economic rebound, after the sense of gloom in the waning days of the UPA-II administration. These expectations sent the stock market indices soaring. Two recent news reports give us an occasion to evaluate where we are, seven months later. One is the apparently welcome news that the annual wholesale price inflation for November 2014 was down to zero per cent. The other is the less welcome news that the industrial output in October 2014 had contracted to 4.2% as compared to a year ago. Indian factories are confronting the fact that people are not able to spend. The GDP growth for this year is expected to remain modest, at around 5.5%. So what is happening to the Indian economy? Infrastructure development — highways, railways, the National Optic Fiber Network, Smart Cities, the Pradhan Mantri Gram Sinchai Yojana — is at the core of the Narendra Modi government's agenda. These ambitious programmes need money. Government ministers have been saying that interest rates are too high for projects to be economically viable. But RBI Governor Raghuram Rajan has been sticking to his guns, citing, among other factors, the risk of food inflation to justify leaving his interest rate at 8%. Before we weigh in on this debate, let's take a moment to understand RBI's role in managing the money in circulation. The money we use has been created by the RBI and lent out into circulation. When the loans are repaid, the money is taken out of circulation. (The interest earned by the RBI is given to the government for its use, and thus remains in circulation.) When the RBI lends more than what it receives as repayments, the money supply increases. When the amount lent is lower than the repayments, the money supply decreases. The amount of money that gets borrowed from the RBI depends on its interest rate (the "Repo rate"). A lower interest rate tends to expand the money supply, and a higher interest rate tends to contract it. Thus, the RBI's interest rate controls how the money supply changes. If the money supply increases faster than the output of the economy, there is inflation. People are encouraged to transact, to use their money before it loses value. This charges the economy, but excess inflation will discourage savings, and lead to misallocation of resources (e.g. investing in gold). If the money supply increases slower than the output, there is deflation. Money becomes more valuable simply by "keeping it under the mattress". People are encouraged to postpone buying anything, because they expect to get lower prices tomorrow. This sentiment dampens economic activity. Furthermore, when people keep money out of circulation, the available money reduces further, which leads to more deflation. This vicious cycle, called a "deflationary spiral", leads to stalling of the economy. For prices to remain stable, money supply should expand at the rate of economic growth. The consensus is that a low positive rate of inflation is best — it penalises "keeping money under mattress", encourages economic activity, but doesn't cause misallocation of resources. The moral of this discussion is that monetary policy has deep implications. It is like a temperature control knob for the economy. Not getting monetary policy right can have devastating consequences. In fact, the renowned American economist Milton Friedman has shown that the Great Depression in the US (1929-1933) was a period of acute deflation, caused by the US Fed contracting the money supply by over 33%. Let's look at what's happening to the money supply today. If we expect say 5% economic growth and 4% inflation, then money supply needs to grow at an annual rate of 5+4 = 9%. However, as per the latest data (5 December 2014), the money supply ("Reserve Money" in the RBI's terminology) has actually increased in this financial year by only 1.7%. This shows that the RBI's current rate of interest is unaffordable, and that the money supply is not expanding fast enough to allow for growth. The economy is being squeezed in a cash crunch, as in the Great Depression, though not as extreme as yet. It is, therefore, not surprising that the November Wholesale Price Inflation was at 0%, and the October industrial production showed a 4.2% contraction. We are on the brink of deflation, and further squeezing of money supply carries the risk of falling into a deflationary spiral. There is ample justification for reducing the Repo Rate in a calibrated manner, with the goal of increasing the Reserve Money at an annual rate of 9%. This means that the amount lent by the RBI this year should exceed repayments by Rs 1.56 lakh crore. It is important that the increase in money supply be used in the most efficient manner. It may be best if the funds are lent for the purpose of building productivity-enhancing infrastructure. Such spending triggers a cascade of expenditure by businesses and their employees, and also leads to increased output through the infrastructure created. The eventual economic impact can be many times greater than the initial monetary expansion, without inflationary consequences. Furthermore, as economic growth picks up, the Reserve Money growth rate can increase beyond the initial 9% suggested for this year. Such a programme, over the next four plus years of this government's term, would go a long way towards enabling the Modi government to fulfil its commitments on infrastructure development. We disagree that the fear of food inflation necessitates a tighter monetary policy. The agriculture sector amounts to only about 11% of the GDP. It is unjustifiable to subject the entire economy to a cash crunch because of any production shortfall in agriculture. In fact, higher food prices, and development programmes like the Gram Sinchai Yojana, will naturally lead to higher agricultural production, which in turn will curb food inflation.
A parameter which often gets attention is the fiscal deficit, which is the amount by which government revenues are short of expenditures. This amount must be made up by borrowing. Finance Minister Arun Jaitley inherited from the UPA a fiscal deficit target of 4.1% of GDP for this year. Fiscal deficits are indeed bad if the money comes from an uncontrolled increase in money supply, because that causes high inflation. However, as long as the increase in money supply is matched by increased economic output, borrowing from the RBI is not a problem. Therefore, it is better to watch the money supply and the inflation, rather than worrying about fiscal deficits per se. The "Mid-term Economic Analysis" released on 19 December advocates reviving public investment as one of the key engines of growth, which we agree with. Our suggestion is that a Reserve Money expansion of about 9% this year (and maybe more in coming years) can contribute to funding this investment, without causing excess inflation. The buck ultimately stops with the political leadership, who should ensure that the infrastructure and growth agenda of the Modi government is not throttled by overly tight RBI policies, and that funds made available by monetary expansion are used in the most productive way possible. |
