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While the new Reserve Bank of India (RBI) governor Raghuram Rajan effect on rupee is visibly increasing, an IIM Ahmedabad (IIM-A) working paper suggests there is more to be done, especially in terms of increasing liquidity in the market, and improving the regime for private investment.
Titled 'Way Out of Current Macroeconomic Mess: A Note', the working paper by IIM-A faculty member Sebastian Morris states that a possible solution to the current situation of large current account deficit (CAD), low growth and plunging rupee is if credit can be expanded by the RBI while the government comes out with an appropriately structured investment tax credit (ITC) valid for the next 24 months that can be accompanied by a large push on investments.
"Three things need to be done to arrest the current situation. Firstly, credit needs to be expanded which would close the difference between low end government bond yields and the repo rate. Secondly, this will encourage more investments and its impact will also be seen on the stock market. Thirdly, the rupee should not be allowed to appreciate. The new RBI governor has at least hinted that he would not control both the policy rate and the money supply through credit rationing, i.e. by closing the repo window prematurely," says Morris while elaborating on the working paper.
On the ITC, Morris suggests that the ideal form it should take would be a 50 per cent tax credit on all investments, especially in manufacturing, made from now on over the next 24 months which can be set off against future taxes to the paid. "Thus if an industry makes a spending on investment then it would earn (tax) offsets to the extent of the spending on future taxes. This would break the pessimism, and as a few companies make the investment others would follow for reasons of competition and rising demand," the paper suggests.
As per the paper, the recession in economy had been anticipated in 2011 when on one hand the government exited from fiscal stimulus while on the other hand RBI began raising repo rates. Both put together, the paper states, brought investment levels to practically nothing at all. Morris argues that while these actions were sought to be justified on account of high fiscal deficit and high inflation, the effort was futile.
"It is silly to fight a supply side inflation on basic food in a poor economy by killing off demand for autos, durables, real estate, and manufacturing which is what would happen when interest rates are raised and credit is put on a tight leash," the paper argues.
Morris' paper is of the view that the biggest mistake made by the RBI was during 2007 -2008 over the year before the global crisis, when instead of keeping the nominal value of the rupee down it allowed nominal appreciation having lost the ability to carry out sterilisation in the wake of large capital inflows during this period.
Further, a CAD higher than two per cent of GDP would be non-sustainable which India reached non-sustainability when its growth fell to 7 per cent and CAD to 3.5 per cent - a situation where non-debt creating inflows such as FDI and FII could not be serviced or used to finance CAD for long.
"In other words the rupee was overvalued and had to come down," the paper adds.
Commending Rajan, Morris says that under the new RBI governor with a commitment to liquidity through the repo window or by raising the repo to eliminate the rationing situation, the repo should collar the low end bond yield rates, allowing the repo to be truly policy rates.
"Given the recession it is important that rather than raising rates the liquidity needs to be expanded to even lower the repo rates. This position needs to be kept up even if money supply rises beyond targets," the paper offers as a remedy to the current situation.
