Inflation Targetting is Hurting

In light of Subramaniam Swamy's campaign to ensure that RBI governor Raghuram Rajan does not get a second term, Hardnews deemed it necessary to highlight an article from our archives which sheds light on the controversial inflation targetting policy of Raghuram Rajan

RBI Governor Raghuram Rajan’s refusal to lower rate of interest when the economy is tanking is very intriguing
Sanjay Kapoor Delhi

The denial never came from the two people who matter: the one who gave the interview and the one who took it. Ajay Shah, an economist with a government-funded public finance institute, was interviewed by the London-based Financial Times on the Reserve Bank of India and its Governor, Raghuram Rajan. In the interview, Shah said, “Raghu was doing the bidding of Prime Minister Narendra Modi in keeping the rupee strong.” He further reiterated that the RBI Governor, who had a cultivated image of a person taking on the corrupt political class, was doing “whatever the PM wants him to do”. Knowing the implications of what he was saying, the finance ministry issued a denial and also sought clarification from him.

Shah’s remarks cleared the air on what is really happening in the government as well as what Prime Minister Modi expects from those running the economy. The RBI Governor may seem to be in ideological opposition to Finance Minister Arun Jaitley and his constant exhortation that the rate of interest should be brought down by the central bank to kick-start a moribund economy, but the PM thinks differently. He wants the rupee to be strong, because he takes it as a sign of health of the economy.

During his campaign in the 2014 Lok Sabha elections, he had mocked at the speed at which the value of the rupee was plummeting – saying derisively that the rupee’s value against the dollar equalled former Finance Minister P Chidambaram’s age. In 2013, for a brief while, the rupee’s value had fallen to about `70, which made the economy, squared against Modi’s paradigm, look just terrible.

This was the period during which exporters were making merry and manufacturing had begun to revive. To reiterate, a regime that promotes austerity through high interest rates does badly everywhere. Economies revive when the currency is allowed to devalue to reach its real exchange rate. The crisis in Greece, besides many other factors, has been aggravated by the inability of the government to manage its monetary policy and allow the currency’s devaluation. Surely, such conditions cannot be allowed in a country as poor as India.

Prime Minister Modi sees merit in inflation targetting  and use of rate of interest as a tool to bring down prices and appreciate the rupee. What does this really mean for many of those business houses that supported him in coming to power? Do they benefit from a regime that is so parsimonious in lending money? And there are still more questions about how the PM is responding to the demand for change at the top in the finance ministry for failure to revive the economy.

Is Rajan being favoured for the top job in the ministry or is he targetted for ouster from his job? Was there any substance in the attempts of the finance ministry to rein in Rajan by setting up a Monetary Policy Committee (MPC) on which he is denied veto power to decide the rate of interest? The answers to these questions provide clues as to whether change is coming to the finance ministry.

Just before the August 4 announcement of the latest policy rates  – when again Rajan was unmoved and chose to preserve the repo rate- the rate at which the RBI loans money to banks  –  there was a flutter that Rajan’s wings were being clipped with the finance ministry’s announcement of the MPC that would take away his veto power. The basis of this speculation was the report of the Financial Sector Legislative Reforms Commission (FSLRC) that suggested putting together a new financial code aimed at the goal of the central government – to strike a balance between achieving price stability and  growth. This mandate of the new financial code was meant to take away the veto power of the Governor and realign RBI objectives to attain growth rather than just ensuring inflation control. Rating agencies like Moody’s cautioned against such a move, compelling the finance ministry to beat a hasty retreat—denying any bid to tame a Governor who would not heed the pleading to reduce the policy rate. On August 4, Rajan triumphantly stated that the status quo had been maintained as he still had veto power, though he had claimed to see merit in its withdrawal.

Many of the companies that are bleeding failed to get any relief from the RBI. Why do companies get hurt through inflation control? The transmission from interest rates to inflation takes place through controlling demand and supply. When there is an increase in interest rates, aggregate demand falls – hurting investment and consumption. Companies in heavy debt are cracking up in this difficult environment. Hindustan Construction Company, Jai Prakash Associates and scores of other companies are staring at huge debts. Many of them had over-leveraged during the boom period of 2007-08 and since then have been finding it difficult to turn the corner due to poor market conditions and high interest rates. There are many companies that are bleeding and their poor performance is manifest in every possible business and economic indicator. In Delhi and the NCR, the collapse of demand is so visible that there are ghost colonies that have come up all around. The colonies constructed along the Delhi-Agra highway and near the Formula 1 track have just a handful of takers. Desperate advertising and reiteration of how the approval for construction of an airport in the area can spike realty prices is not helping the builders as there is just no money in the market. This is the time for business houses and individuals to hoard money.

Then there is a huge pile-up of non-performing assets of the public sector banks –  about 5.17 per cent with the stressed assets ratio being 13.2 per cent.  Many banks are hiding their toxic assets and Rajan has demanded that they should be revealed without delay.

What this policy environment is really doing is creating circumstances for quiet takeover of such companies that are now going for throwaway prices. The market is abuzz with reports of how predatory finance is targetting companies that are wobbly. Many of them may have benefited in the licence permit raj, but their loss in value is not finding foreign investors or Indian blue chip firms. Invariably, those who are targetting them at these throwaway prices are mostly fat cat NRIs. The moot question is, why is  such a policy being pursued that is squeezing the money out of the market and pauperising businesses and people? Is the economy being reordered to facilitate foreign companies to make in India by taking existing businesses or is there a larger design? A former Cabinet Secretary says the government has little control over the RBI Governor. He would perhaps listen more to what the Secretary of the US Treasury or the Governor of the Bank of England have to say about interest rates than India’s finance minister.

What is really intriguing is how this disturbing reality is being hidden behind the Potemkin of  the new growth rate of GDP, which is shown to be a high of 7.1 per cent. So dodgy are these numbers that even Chief Economic Adviser (CEA) Arvind Subramanium, who authored the Economic Survey, seemed unsure of how the statistical office had arrived at these numbers.

Growth has stumbled in economies that have adopted inflation targetting such as Brazil and South Africa. Their growth rate was struggling at 3 per cent over 2000-2006  when other economies were above 5 per cent. The Indian economy was doing very well during this phase when inflation was not being targetted.

Ever since inflation control occupied the head space of the politicians, who were not really bothered about removing supply constraints, growth has become a casualty. Former RBI Governor Duvvuri Subbarao, who also followed a tight monetary policy, had cautioned against the central bank confining itself to controlling prices in an economy in which  growth is critical.

The Urijit Patel Committee’s recommendation to make inflation targetting the RBI’s mandate handed more powers to the Governor. The committee also wanted the interest rates to be anchored in the Consumer Price Index (CPI) rather than the Wholesale Price Index (WPI). There has been opposition to this shift, which builds on the fact that the CPI is difficult to predict and so the interest rate should not be pegged to it.

All these issues did not faze the Governor during the recent review of monetary policy, Rajan was unmoved by those who reminded him of the low CPI and the plummetting commodity prices. He also did not take cognisance of the dismal performance of 1,600 companies listed on the Sensex that have seen their profits shrink by 19 per cent in the last quarter of 2014-15. For the first time since 2008-2009, when the murderous recession hit the world, none of these companies has shown any growth.

The high interest rates have also appreciated the rupee to a level where the real exchange rate is probably the highest it has been since 2011. This has resulted in cheap imports hurting the Indian manufacturing and export sector. Interestingly, there has been no study by the government to ascertain how growth and  employment have been impacted by  inflation targetting. There are some sketchy observations by the RBI that do not suggest high policy rates have any influence on economic distress.

However, there is plenty of information that has come from other emerging markets. Brazil over 2000-2006 is a case in point. Researchers discovered that its inflation targetting policy imposed hardship on the working class. What was also apparent was that the rate of inflation was hardly impacted and that raised serious questions about the accountability of the Reserve Bank. Although his theory was challenged, the father of monetarism, Milton Friedman, said that the expectations of workers do not remain stagnant with inflation but follow the movements of the rate of change.

In India, too, what the RBI has done has not really helped in controlling prices. Any dip in inflationary trends has more to do with falling commodity prices. The RBI is convinced that reduction in the rate of interest will not help an economy saddled with such a huge debt overhang. In 2014-15, the infrastructure debt, according to a Business Standard report, as a percentage of sales was a whopping 256 per cent. Add another 19 per cent of interest cost to this and it becomes a humongously unattractive proposition for anyone wanting to make anything in India.

Rajan has made light of what interest rates are capable of in the economy. The recession-hit economies of Europe provide ready examples for Rajan to say that demand does not revive even if the rate of interest is brought to 0 per cent. He believes that its rise and fall do not really improve the aggregate demand. In his address at the Economic Club of New York in May, he said that economy does not really revive due to  debt overhang. 

He further said that the incentivisation of investment through low tax rates and low rate of interest cannot work if ultimate consumer demand is weak due to debt overhang – as the real return on new investment might collapse. He cautioned governments that their attempts to increase spending by borrowing will not work and only add to their debt. Although he does not say this in so many words, he thinks that there is not much that the RBI can do if the economy is in a bad shape.

If that is truly the case, then why keep the rates so high? Is it because of his desire to tame the crony capitalists or is there something more?