Sharp cuts in interest rates can heal a bruised economy

The 2014 elections are only four to five months away. The Manmohan Singh government, therefore, has at most eight weeks in which to take economic policy decisions that can end India’s four year recession before the time for decision-making expires. In concrete terms this means the end of December. Since this is also when the RBI will present its next mid-quarter policy prescriptions, it means that the ball will land squarely in Raghuram Rajan’s court. 

In his three months as the Governor of the RBI, Rajan has made three important policy statements. All of them have shown a fixation upon controlling inflation: in none has he shown the slightest concern for growth. His second quarter policy statement on October 30 is the most explicit. In it he comes within a hair’s breadth  of saying that growth is not a goal to be pursued for its own sake. It will happen automatically when the government sets everything else right. At the head of his list is inflation. Rajan believes in an ‘activist’ monetary policy, i.e in one that keeps the nominal rate of interest higher than the rate of inflation. So, to the intense disappointment of industry he has continued with his two predecessors’ high interest rate policies.

When Rajan took over as the governor of the RBI in September, the exchange rate was in free fall and panic was spreading like poisonous gas through the Indian and foreign investors’ community. Today this dark moment has receded into the past.  The exchange rate has stabilised; the panic driven interest rates of July 16 have been brought down, in line with the RBI’s other policy rates. Foreign investors are coming back, gingerly, to the Indian market and the foreign exchange reserves have begun to rise.  If the rupee is still depreciating marginally, it is by design, because Rajan is impounding the foreign exchange inflow taking place on the capital account to raise India’s foreign exchange reserves instead of letting it flow into the economy.

But the crisis is not over.  The US Federal Reserve has only postponed the tapering of its fiscal stimulus programme. The moment it begins, the rupee will once more come under pressure.  But there is a far blacker cloud on the horizon: More than 200 of the largest and most reputed companies in the country, which issued convertible debentures in the international market six years ago, are unable to convert them into shares because of the 40 per cent depreciation of the rupee since 2007 and the sharp decline in share prices since 2008. India thus faces the biggest collective default on private international commitments since the East Asian meltdown of 1997. 
Should this default occur, the shock will cause an exodus of foreign investors that will plunge the country into a foreign exchange crisis of 1991-like dimensions once more.

The only thing that can avert both of these threats is a sharp, broad-based and sustained recovery in share prices. And the only thing that can bring this about is the long-awaited sharp cut in interest rates. A lowering of repo rates and the cash reserve ratio will force commercial banks to cut their deposit and lending rates. The first of these will shift investment in bonds and bank deposits into shares. The second will revive borrowing, first for consumption; then for purchasing homes, and finally for investment. Rising share prices will neutralise the pull on FIIs of rising bond prices in the US when the Fed begins to tapers its fiscal stimulus programme. But, more importantly, it will allow most of the debenture issuing companies facing default and catastrophe abroad to fulfil their conversion commitment and allow the rest to ask, credibly, for a little more time.

In the real world that obstinately refuses to conform to Chicago school dogma, the only risk India would run by lowering interest rates is of the rise in imports that will follow the revival of demand. 
This risk seemed very real in June and July when the current account foreign exchange deficit (CAD) was running at  4.9 per cent of GDP,  foreign exchange reserves were falling, and the US federal Reserve’s announcement that it would phase-out its fiscal stimulus programme was sucking FIIs out of India into the US bond market. But it has almost completely disappeared now. The ‘Fed’ has postponed its phase-out; NRI money has flowed into the country under two new schemes announced by the RBI,  FIIs have begun to return to the share market and foreign exchange reserves have at last started to rise.

Best of all, a close examination of the trade data shows that India’s current account deficit is about to vanish. Exports are rising at 11-13 per cent and imports have fallen sharply. The trade gap has narrowed in the first half of 2013-14 (April-September) by just under $12 billion. This has led the finance minister and others to predict that the CAD will fall from $88 billion last year to around $60 billion this year.  But this estimate is too pessimistic.

The first half’s figures have been distorted by a huge speculative import gold, worth $15.45 billion, in April and May. Since June the trade deficit has averaged $10.7 billion against $15.7 billion in 2012. If this trend is maintained the 12-month deficit, measured from June to May instead of April to March, will be in the neighbourhood of $128 billion. If the net services income from abroad stays at last year’s $108 billion the current account deficit will shrink from $88 billion in 2012-13 to $20 billion. This is just about one percent of the GDP. In fact if the rise in exports continues it will be even smaller.

India, therefore, has an ample and growing cushion to absorb the rise in imports that precedes the revival of growth. There is therefore no downside to lowering the interest rates now. All that Raghuram Rajan has to do is abandon the belief that raising interest rates is the cure for all types of inflation; recognise that India is suffering from endemic cost-push inflation born of supply shortages, and that the only cure for these shortages is economic growth.

The writer is a political commentator.