Monetary policy can wait

Subir Roy

Senior economic analyst

The ordinary Indian consumer has reasons to feel some of the latest developments, if anything, are lowering his confidence in spending. This is at a time when the aim of the policy should be to revive consumer confidence so that spending and demand pick up and pull the economy out of the sharp slowdown which has gripped it.

The country’s largest bank, the State Bank of India, last month lowered interest rates for some of its longer term fixed deposits. This comes at a time when consumer price inflation has touched a new high of 7.35% after rising continuously and doubling in the past six months. Lower interest earnings, at a time of rising prices, are tailor-made to prompt consumers to hold on to their cash and not spend.

The latest monetary policy review has described the current inflationary situation as ‘highly uncertain’, which is a euphemism of sorts. At a time when the inflationary impetus is so pronounced, the logical thing to do would be to make money tight — raise interest rates — so as to curb demand and let prices come down.

But putting brakes on spending is hardly logical when the economy needs pepping up to move on to a higher growth path. The monetary authority, the Reserve Bank of India, has therefore tried to square the circle. It has kept interest rates unchanged and simultaneously lowered the amount of bank deposits impounded through the cash reserve ratio — the portion of deposits a bank has to keep with RBI — to the extent of loans given in selected categories.

Thus, with more funds at their disposal, it hopes banks will go out and lend more. This should pep up spending and demand. If this is an unconventional way of doing things, that is perhaps what is necessary at a time when the economy seems headed for ‘stagflation’ — stagnant or falling growth and inflation going hand in hand.

But it is doubtful if banks will go out and loosen their purse strings simply because they have more cash at their disposal. The current mood in banks, particularly public sector ones which account for two-thirds of the sector, is sombre. They still have to provide for the mountain of bad debts they have acquired, making the current non-performing assets of the Indian financial sector the highest in the world.

Banks will change their sentiments only when they see economic players around them looking at the immediate future more optimistically. This is precisely what is absent. Businesses are tight on cash, suppliers’ payment schedules are getting longer and the last thing that businesses right now want to do is produce more and begin to think about capacity expansion.

This mood has even touched the NGO sector which survives on the charitable disposition of the public and companies, as also the tax incentives available to the donors. The Budget has just put a spanner in the works by lowering tax slabs in return for having to forego exemptions. Taxpayers will ultimately choose a path that will leave them better off. If this means moving away from the tax relief that donations to eligible entities bring, the NGOs which provide a crutch to the poor and disadvantaged will be worse off.

What is more, removing incentives for savings is highly undesirable at a time when the national savings rate is down. A high savings rate was a key factor in the Asian tigers being able to achieve a high rate of growth through high investment. The savings rate needs to pick up after the dip brought about by the 2008 global financial crisis. Plus, incentives to raise long-term personal savings can help people share the State’s social security burden. India surely is not ready for the low savings and heavy dependence on plastic money which characterise developed economies.

The monetary policy, for its part, has tried to ensure that banks which need funds to lend can take recourse to borrowing from the RBI through the ultra long-term repo operations, whereby cash is available at the repo rate which forms the benchmark for the market. This announcement led to a fall in bond rates, that is, the rates at which organisations issue instruments to garner funds.

But again banks are not lending, not because they cannot access affordable funds, but because borrower are not coming forward with viable projects in which they can risk their own money and that of the banks. Again, the RBI has allowed banks not to have to downgrade their loans for projects which have been stalled due to no fault of theirs, for example, for environmental reasons. This will be helpful in the short run.

India’s monetary policy suffers from a long-term deficiency — poor transmission, that is, policy rate changes not being passed on to customers. But the dilemma right now is that both borrowings and long-term savings have to be simultaneously encouraged. Plus, banks and non-banking financial players have to be encouraged to clean up their Augean stables.

At a time when contradictory demands are being made on monetary policy, the problem may lie on the supply side. Prices are going up, not because too much money is chasing too few goods, but the agricultural economy, and in particular the marketing of agricultural produce, is flawed. Plus, banks and financial institutions are busy setting their own house in order and not applying their minds foremost to upping lending. So, the twin tasks before the policy makers are to set right agricultural marketing and rapidly take forward the cleanup of the balance sheets of financial institutions. Monetary policy can meanwhile wait.

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