Frostbite

When I returned from Sunday evening walk, Venky was commenting ‘you are back dear so early; need to toil a lot if you want to cut down your flesh’. Yeah he is right. If one is serious to get back to usual size, one needs to work out more seriously, but not so seriously that limbs develop cramps. Only last month I embarked on weight reduction program, after my body turned bulging. Till a few summers back, I was a regular freak at the Sanjay Gandhi Park jogging either in the morning or evening; time permits. But with increasing official and personal commitments, I slowly veered away from my regular. The result is protruding belly.

Similar is the problem with Indian economy. After struggling with Hindu rate of growth for nearly four and a half decades, with the advent of liberalization and globalization, economy had finally taken off well and had become a darling in the emerging markets. When the party is going on well, comes devil in the form of inflation. You might say this is a known devil. The point is why we have not put the lid. The problem with mortals particularly we Indians is that we don’t take anything seriously until and unless it threatens seriously.

The reasons for galloping inflation are said to be raising food and commodity prices, acceleration in credit growth and M3 money. The focus of this article is only on monetary aspects, leaving supply side constraints for discussions on some other day. Till November last, inflation was not on our radar at all because of the solace derived from the fact that it had been hovering within RBI’s tolerance band 5-5.5. We raised alarm only when it shot up by 100 basis points. Ruling party’s rout at the hustings in Punjab and Uttarakhand is attributed to high inflation. The role historically played by anti incumbency factor had been forgotten this time. A look at the past twenty years’ state election results show that voters cutting across regions rejected the incumbent party. Exceptions are left wing’s rule in West Bengal, Digvijay Singh’s return to power in 1998, Chandra Babu’s nine years innings during 1995-2004 and Delhi’s Shiela Dixit government for the last eight years. However, this time most of the analysts had conveniently chosen inflation as the culprit for ruling party’s defeat. No doubt, inflation like indirect taxes hits aam admi heavily, owing to its regressive nature. But to squarely blame the State Governments for macro economic nuances is a bit unfair.

RBI has already raised panic buttons. It is under tremendous pressure to bring the inflation back to the prescribed threshold limits. But the moot question is why RBI is rushing to crush inflation by applying ‘air brakes’; steeply raising interest rates and Cash Reserve Ration (CRR), whereas our law makers recently empowered it to reduce CRR. Does not it suck much liquidity and starve a shining economy in the process? Visible signs are already there to witness across the spectrum of economic activities. The hardening interest rate regime in the meanwhile has fully become functional and taking its toll heavily on retails borrowers, who are feeling the heat by forking out fat EMIs month after month. The fear of defaults may force banks to reduce their exposure to housing and retail sector.

See, I can cut down my belly either by cutting diet (like Adnan Sami) or by arresting myself for four hours a day in a nearby gym. Would you recommend such a course of action? Anyone with average intelligence and basic common sense would suggest that a judicious mix of both, applied steadily over a period of time, would yield the desired outcome without any collateral damage. This is precisely the point RBI missed this time. Rising repo rate coupled with hiking CRR expectedly cripples the credit growth. The classical economic theory supports such a course aimed at bringing down the demand for goods, which eventually weaken prices and thus inflation. But the context has changed. Globalization had ushered in open markets. Big and not so big corporates have been resorting to external commercial borrowings, available at much cheaper rates. (Hope, ceiling on ECBs now at $500 million is not brought down as part of war against inflation), Adding to the problem of money supply is the inflow of foreign funds, which have been chasing rapidly progressing markets like India. The unintended consequence of the whole process thankfully is the restricted role of central bankers. The leeway available to central bankers is fast receding.

One of the principal jobs of central bankers is to keep money supply growth in line with the real GDP growth. Real GDP remained at 5.2 during 1990/91-2002/03, went up to 8.1 during 2003/04-2004/05 and then to 8.3 during 2005/06, and current year estimates for fiscal 2006-07 vary from 9.2. to 9.6; whereas the money supply growth at nearly 20% has been far ahead of 15.5 per cent target set by RBI itself. They say ‘trend is your friend’. In this case, the trend is clearly on the wall. The widening gap between the GDP and money supply is telling for the last few years. But attention was not given to address this issue appropriately. The inescapable conclusion is that the system either failed to catch the evolving trend much earlier than it becomes reality OR became ineffective to treat the symptoms.

Furthermore, the RBI is hell-bent on holding the appreciating rupee for the sake of safeguarding exports, particularly IT and IT enabled services, in the process purchasing foreign exchange and pumping rupees in the local market. Was it not aiding inflation to accelerate? There lies the quandary. Why don’t you allow appreciation of the rupee, at least temporarily if you are so serious about taming inflation? Our goods and services anyway have saleability in the international market on account of comparative advantage. Mind you, appreciating rupee has its benefits. Imports become cheaper. Secondly, non-intervention by RBI in rupee’s upward and downward movement against greenback, at least temporarily, constricts the money supply, which will soften inflationary pressures.

Economy is no doubt heating up. If the intension is to slow down the pace of growth, sprinkle water but don’t pour water. It takes not months but years to even warm it up again.