That we are facing a deepening economic downturn is beyond doubt, and as the experience of Great Depression shows, when Governments are slow with their monetary and fiscal policy responses, the consequences can be disastrous. It is a different matter as to whether this is enough or what types of specific policies are suitable, but suffice to say that substantive monetary easing is a simple first line of defence.
The RBI did cut rates in the first week of January, lowering the repo rate by 100 basis points to 5.5%. But unlike the US and much of the developed world, where monetary policy has run its course and where fiscal stumulus spending has assumed centerstage, monetary policy will have to lead the war against recession in India for a number of reasons. This leadership role for monetary policy demands much more dramatic monetary easing than so far done, and as quickly as possible. Here are a few possible reasons in support of this case:
1. Though the bank rate is 6%, the real rate (and it will be interesting if somebody could model this and find out a figure) is surely much higher given the premium arising from rational expectations on the counter-party risks prevalent in the credit markets, a condition that has led to a severe credit squeeze with bankers sitting tight on liquidity.
2. The inflation outlook is very benign. Inflation is on a continuous and steep deceleration trend, with the latest figures showing the annual WPI based inflation at 5.91%, with prices falling across the board, including for food items. The agricultural production has been good and stocks have built up to comfortable levels. The global recession will keep commodity, foodgrain and energy prices at low levels. In fact, globally the worry seems to about deflation and not inflation. Lower rates are not likely to come in the way of any immediate or even medium term inflationary pressures. Economic growth and not inflation should be the driving factor behind monetary policies now.
3. The classic definition of aggregate demand is the sum of Consumption (C), Investment (I), Government expenditure (G) and the net of exports (NX). Unlike the US and much of the developed world, we have limited leeway with G (given the tightly constrained fiscal space), but enough scope for stimulating I and even more with C. Both I and C are critically dependent on interest rates, and can be stimulated substantially with monetary loosening. However, in such times of bleak economic expectations, the loosening has to be dramatic enough to evoke the desired response in both businesses and consumers.
The NX element remains the enigma, more so given the specific circumstances now. I am not sure how much effect will the export sector sops in the recent fiscal stimuluses will have, especially given the anemic external trade environment. How are these measures going to act, and how much will they deliver in terms of increased exports are interesting questions? Some study on this will surely throw up interesting results. I am inclined to believe that the efforts in this direction are not likely to deliver much results, beyond acting as corporate stimulus to shore-up the bottom-lines of exporters. In any case, with exports forming a relatively small (and those affected by global recession a miniscule portion) share of the economy, the impact of efforts to boost the economy will in all likelihood be small.
4. So far the RBI's monetary policy responses have been focussed more on the liquidity side - auctions, CRR and SLR rate cuts etc - all of which have only an indirect effect on the interest rates. The result has been that banks are now sitting on liquidity, but unwilling to lend for lack of assured lending alternatives. In contrast, interest rates have a more direct transmission effect on the economy, more so on the critical sectors. It is presumable that lowering the rates further will make more (credit worthy) businesses and consumers interested in borrowing, besides lowering their debt repayment burden.
5. We may actually be in for a long haul with the economic slowdown. The economies of US and elsewhere in the developed world may start on the recovery path well after 2011. Any stimulus will therefore have to keep acting for atleast the coming four to five years. India does not have the fiscal space to sustain a spending stimulus for so long. In the circumstances, the role of investments in infrastructure, especially by the private sector, assumes importance. And this is in turn critically dependent on the interest rates on offer.
6. Interest rates have a cyclical dimension to it, which assumes greater significance at times of economic crises. With inflation on a downward trend, atleast for the immediate future, the cyclical factors demand that rates be lowered sharply. A loose monetary base leaves the Central Bank with greater scope of options when the cycle comes the full circle to the inevitable rise in inflationary pressures (a couple of years down the line). The challenges ahead are formidable, with the combined fiscal deficit set to go well beyond 11-12%. Its impact on inflation and interest rates will be significant, and the RBI will need sufficient space with monetary tightening without too adversely impinging on any fledgling economic growth.
In many respects, the central elements of the stimulus measures announced by the Government of India are monetary policy based. The fiscal measures announced are too small to have any meaningful impact on an economy as large as India, especially when faced with such strong global headwinds. It is therefore imperative that the economy be provided with the fullest monetary policy cushion to tide over the weak economic conditions.
Given the controversy and debate surrounding macroeconomic policy making during economic crisis, there cannot be any settled long or medium term set of policies for such times. Policy makers can at best respond to the incoming signals and respond with the avaliable policy levers, and given the extent of slowdown there arises a need to take extraordinary measurse and respond as aggressively as possible. The need of this hour is aggressive monetary loosening and the conditions appear benign enough to sustain this.
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