The Indian Policy Week

This article of mine was published in Hindu Business Line yesterday on March 14, Link . Haven't written something exclusively for this blog in this year but working on an interesting concept (a little philosophical though) that would need extensive development, so posting on this blog would be the first step.

With the budget and the RBI economic policy coming up, this week would see both the fiscal and monetary policy in action and thus could end up sealing this year’s economic course. The RBI has already made its move with a 75 basis point CRR cut, however the more critical action on interest rate is needed now and at the same time the government should show some teeth by cutting back on its ultra-loose fiscal policy stance by bringing its expenditure under control, perhaps it is too much to expect from the besieged but certainly that is what is needed to rejuvenate the faltering Indian growth engine.

The RBI has already cut the CRR by 125 bps in the last two months. To put this into perspective of how grave things are; a CRR cut of this magnitude or more has been witnessed only twice before in the past decade, once during 2001 post Sep 9/11 and the second during the financial crisis of 2008 post the Lehman collapse.

Certainly there is some seasonality to the liquidity issues involved but what should not be missed are two serious structural underpinnings; slowdown in private sector credit growth and slowdown in the growth of forex reserves in the past two quarter.

Ever since the end of financial crisis of 2008 the private credit growth started to recover but unlike in earlier times in the past 2 decades this was accompanied by an increase in the government credit growth as well.

As can be seen in the graph; since 2009 unlike previously whenever private credit growth started to take off the government credit growth used to taper off thus enabling the country to tread on the path of high growth with moderate inflation (the golden period from 2003-2007 as can be seen in the graph). However post 2009 both the private sector and the government sector credit have seen a rapid increase, unforeseen in the last two decades.

The government credit growth has largely been as a result of its re-distributionist policies that is causing serious misallocations of capital and not having much of an effect in increasing the real supply, thus reducing the economic productivity. This has resulted into a near double digit inflation for the past 2 years.

The RBI with all its good intention tried to reign on this unabated credit growth and thus the inflation with the increase in the interest rates. Unfortunately the fiat monetary system that we are living in is like an inverted pyramid scheme which implies that even a moderate slowdown in the credit growth can cause severe stress in the system. So as a result of the increase in the interest rates by the RBI the private sector credit is only expected to grow by 16% this fiscal compared to 21% last year making it harder for the borrowers to service the debt and thus contributing to the liquidity stress but at the same time the government credit growth which is the real source of inflation continues unabated (expected to be around 25% this year).

The slowdown in forex inflows in the last year and the severe fall in the rupee that made the RBI to intervene in the forex markets has been another source of stress in the system that has resulted in the slowdown in the increase of base money.

The only way to get out of this mess and at the same time to keep a lid on the inflation is for the country to play a three tune symphony by again attracting substantial forex inflows especially in the form of FDI, reduce government expenditure and increase private credit. Hence on the fiscal front it is critical that the government in this budget presents a credible plan in cutting down on its expenditure and at the same time show its resolve to improve the investment climate in the country thus attracting the forex inflows. This would help in improving the stock of base money and maintain the value of the rupee.

On the monetary front this should be accompanied by rate cuts by the RBI, this would translate into higher private credit growth and in turn higher economic growth rate and thus the relieving stress in the system.