The decision by the Reserve Bank of India (RBI) to leave interest rates unchanged has denied the Indian economy a chance to reverse gear and get out of the downward slide in its growth rate. This is unfortunate because there is nothing so wrong with the economy (still one of the fastest-growing economies in the world) that cannot be tweaked and set right, or that can justify its transformation from being a proud member of the Bric community – since the term was coined – to being in danger of becoming the first member to face a downgrade to junk or non-investment grade. What was needed, above all, at the present juncture was a gesture to help turn around sentiment.
The Indian central bank, in line with the harmful conservatism of some of its counterparts elsewhere in the world today, has remained confined to a narrow role borne out of a misreading of economics and added to the problem instead of becoming a part of the solution. It has been emboldened to ignore the signals from the government and the finance ministry, since both have lost credibility. From being a central bank that was historically firmly under the thumb of the finance ministry, it has, in the latest instance, thumbed its nose at its previous superior.
To understand where we are and to take a view on what the right medicine is today, it is necessary to revisit recent economic history. The 2003-08 high-growth period came with a lot of pluses like a robust world-class corporate leadership able to grab the opportunity created by a global boom. But regulatory inefficiencies and infrastructure inadequacies remained. Also, the fruits of growth till then had been rather narrowly distributed, leading to a change of government. So a strong redistributive policy and high growth went hand in hand.
It was wrong to crow over high growth when human development indicators continued to be severely inadequate. But growth was a signal for global business to rush to what was perceived as a key market of the future. This investor sentiment, which the rating upgrade from 2003-04 reflected, was predicated on the policy regime continuing to be favourable to global investors and the economy bearing healthy vital signs like low inflation and fiscal deficits.
Global investors, analysts and rating agencies lived by the same economic orthodoxy and were unable to appreciate the political compulsion, or see the positive side of a redistributive phase. For its part, the government crucially failed to take care of food supply to meet the rising demand created by the employment guarantee programme and an upward pressure on minimum wages.
After the global financial crisis, the next setback was the resumption after a brief pause in the upward march of global commodity prices. Economic orthodoxy led the RBI then to tighten monetary policy to rein in inflation. This caused business perception of future demand to turn negative and investment plans were left on the shelf. Investment expenditure suffered and stellar growth ended.
The second-last straw was a slowdown in the Indian decision-making process, courtesy the eruption of corruption issue and the vagaries of coalition politics. The easing of the foreign direct investment regime, so important for global investors, came to a standstill. Absolutely the last straw was a retrogressive Budget that sought to shift the taxation goalposts retrospectively. The deteriorating vital signs – a high fiscal deficit and inflation, and low growth – caused analysts to declare that the elephant was not dancing any more.
It is important to remember that the inflationary spiral started with UPA-II’s attempt to launch its redistributive policies without taking care of meeting the additional demand for food. The obvious corrective is to go all out to raise food supplies. This, along with the recent fall in commodity prices, should enable the inflation rate to come down.
A lowering of interest rates at this juncture would have begun to improve business sentiment and eventually caused investment plans to be taken off the shelf. The change in rating outlook is in part driven by the fall in the growth rate when that is precisely what the central bank doctor ordered. But inflation persists because it has nothing to do with high interest rates. The latter affects discretionary spend, not the desire by poor people to spend additional income on buying more of absolute necessities.
The dharma of the central bank in a developing economy is to worry about both growth and inflation; in a developed economy about both jobs and inflation. Much of the continuing misery in the world today stems from ignoring half the mandate.