Without a sharp fall in interest rates, growth and employment will not begin to recover

In a week from now, the Reserve Bank of India will announce its monetary policy for the next quarter. Depending on what it does, India will either begin to pull out of the growth slowdown or sink even deeper into it. Finance Minister, P. Chidambaram has told the RBI in no uncertain terms that he expects it to lower interest rates in order to re-start investment and reverse the industrial slowdown that set in two years ago. But the RBI has given no indication that it intends to heed Mr Chidambaram’s advice. October 30 is therefore the day on which Indians will come to know who really rules them—a government they have voted into power or an unelected body of civil servants that takes its decisions in secret and believes it is accountable only to itself.

October 30 could also be the day of reckoning for Dr. Manmohan Singh’s government. When it raised diesel and cooking gas prices last month to reverse an uncontrolled increase in its fiscal deficit, it took the first, necessary step towards an economic revival that will only be completed when interest rates are brought down sharply. When people are compelled to spend more on transportation and energy they will have less left over to spend on other consumer goods and services. Thus, unless the decline in demand is offset by an immediate and sharp increase in investment, the cut in subsidies will deepen the recession, throw even more people out of work and ironically, by shrinking the tax base, ensure that the fiscal gap stays wide open.

The government knows this but, not knowing what the RBI will do and unwilling to force its hand, it is playing Pied Piper to foreign investors and hoping desperately that its many relaxations of rules governing foreign investment in India will entice them into investing heavily in our country. But the damage that has been done to investor confidence by over two years of relentless monetary belt-tightening runs too deep to be repaired so easily. This month Suzlon became the first Indian company to default on its loan conversion into shares at the stipulated price. The reverberations of this default have yet to reach India, but they are bound to be severe, for dozens of other medium sized companies have raised funds abroad through convertible instruments and face the same predicament now.

As a result, thousands of foreign investors who bought Indian convertible debentures are now wondering if they will suffer a similar fate. For them India has become a bad word. Suzlon’s problems can admittedly be traced back to overambitious management. But what finally converted their high risk strategies into suicide was the relentless increase in interest rates from March 2010, the resulting fall in share prices ( only partially reflected by the Sensex), an accelerated outflow of foreign exchange from August 2011 as foreign institutional investors withdrew from the market, and a consequent rapid depreciation of the rupee.

Inflationary straw man

Within the country, investment has fallen by more than 50 percent in real terms in a single year and investment in infrastructure by almost 60 percent. All of this can be traced back to the RBI’s obsession with inflation and utter disregard for growth and employment. And the central bank is once again raising the bogey of inflation. Measured by the wholesale price index, this has risen from 6.87 percent in July to 7.81 percent at the end of September. This, its apologists claim, will make the lowering of Repo rates-- a crucial determinant of lending rates in the market --‘difficult’.

The rise in ‘headline’, i.e overall, inflation is very, very, recent. What is more, it is reflected only in the wholesale price index. The cost of living index has actually declined from 10.03 percent in September 2011 to 9.73 percent at the end of last month.

Even the rise in WPI inflation has been caused by a very late and below average monsoon, a partial decontrol of sugar prices to compensate for increases in the minimum sale price of sugarcane, and a 13 percent rise in the price of diesel. In short, all of the recent increase in inflation can be traced to natural causes and government interventions in the market. So it is difficult to see how severe restrictions on the creation of credit – which can affect only demand -- will bring it down.

As for the core rate of inflation—the most reliable indicator of inflation arising from excess demand -- it is true that both the RBI’s index and CRISIL’s vastly better one (which excludes base metals but includes processed foods) show a rise after February. But this conveniently overlooks the fact that according to both indicators the core rate had fallen by half, from 8 to 4 percent, between last September and February and that, in spite of the rapid devaluation of the rupee since the end of last year, it is still well below 6 percent.

For want of a nail

To sum up, the fate towards which the RBI’s intransigence now will drag India is this: without a sharp fall in interest rates economic growth and employment will not begin to recover; without a marked recovery the UPA will definitely lose the next election; and without a credible performance in them the Congress will, in all probability, fall apart as it nearly did in March 1999.

The government has done a great deal to assuage the RBI’s legitimate fear of a huge fiscal deficit, and should commit itself to doing even more in the coming months. But the RBI must take its assurances on trust, for it can make the next cuts only after industry and employment begin to grow and spending power starts to rise once more. Dr. Manmohan Singh needs to make this clear to the RBI governor and remind him forcefully, as he reminded his predecessor Y.V Reddy when the latter was reluctant to bring down interest rates even after the onset of global recession in August 2008, that when push comes to shove it is the RBI governor who holds his post at the government’s pleasure and not the other way round.

(The author is a senior journalist and economic analyst)

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