Monetary Policy: Squeezing Demand, Income and Growth for Whom?

Monetary policy exclusively focused on fighting inflation, in the contemporary Indian context, is likely to attain limited success and instead might even further squeeze growth potential

Atul Sood & Santosh Das Delhi

It has been a year since the new government in India has been in office. The euphoria and anticipation just after the election results has waned. Even The Economist magazine, on completion of one year of this regime, has not given the government a passing grade. It is complaining of centralisation of power (‘one-man band’) and incapacity to implement any concrete actionplan to kick-start the economy.

In the summer of 2014, the nation was abuzz with anticipation and expectation. The corporate-controlled media felt that a ‘new India’ was going to be built, an India without any apology to the poor. The successful have the first right to succeed and the government has every business to work on their behalf, we were told on behalf of the nation and its rich and middle classes. The poor were supposed to wait.

What has happened in one year is something quite different. The poor were addressed first, rather than the rich. All the ‘rights’ of the poor got redefined and subsidies, that partially percolate to the poor, are being withdrawn. Aadhar, financial inclusion, NITI Aayog and direct transfers have in one fell swoop redefined the entitlements of the poor. Social schemes may have the same or different names, and the Congress may gloat that their social policy agenda has been adopted by the BJP, but the reality is that the poor will now get what the rich and ruling classes want to give them; they have not ‘earned’ any rights or any claim over their entitlements.

Interestingly, what is being debated by the rich on behalf of the poor is that since the market will produce only contractual and vulnerable jobs, what is the ‘deserving’ monthly handout per family – `500 or `1,000 – and with what conditionalities? And how can the new technologies of Aadhar or direct transfer ensure that there are no leakages from the handout? 

From the business point of view, land and labour Bills are stuck and so businesses are not euphoric enough to invest and, consequently, growth has not recovered. Business sentiment is also low because of the global slowdown and inadequate demand push domestically. (The recent Socio Economic and Caste Census has identified only 40 per cent rural households as non-deprived and who have at least one of the 14 parameters that have been used to distinguish the deprived and non-deprived.)

In all this buzz, where does the Governor of the Reserve Bank of India, Raghuram Rajan, and monetary policy fit in?

Monetary Policy Stance

In a recent Reserve Bank of India (RBI) board meeting, Rajan  said growth is recovering and investment picking up. He said: “We talked about the state of the economy, which I would characterise as recovering, that we see some signs of capital investment picking up, and there is a continuing need that the government is trying to address, of putting some of the stalled projects back on track. We also see some signs of capital investment, which is good.”

The problem of demand constraint and inequality also worries him and his take is quite interesting. While speaking to Mint newspaper, ahead of the release of the Indian edition of his book Fault Line, in July 2010, he had said: “….inequality is a problem because people don’t stand at the same level in the long run and see very different opportunities, then their attitudes towards reform are very different. So ultimately, the destruction of a society is when you have extreme levels of inequality and you don’t have an agreement on anything.”

When Rajan took over as RBI Governor in 2013, it was expected that, unlike his predecessor, he would understand the limitations of monetary policy in a more complex and globalised world. There was hope that he would look beyond the orthodox policy advocated by the ideology of monetarism which tended to persuade the central banks to bring inflation targetting to the centre of their monetary framework.

Given the fact that the world was recovering from an unprecedented financial crisis and the limitations of the inflation targetting policy framework were on full display in India and several other countries, the expectation was that he would provide some innovation in his conduct of monetary policy. Monetary policy operates in a particular socio-economic context and it is hard to share the understanding that monetary policy is distribution-neutral. Monetary policy exclusively focused on fighting inflation, in the contemporary Indian context, is likely to attain limited success and instead might even further squeeze growth potential. Any attempt to reduce inflation by raising interest rates may result in a decline in aggregate demand, which can further aggravate the declining output.

Contrary to the expectations, in his maiden monetary policy announcement, he raised the repo rate by 25 basis points, from 7.25 per cent to 7.5 per cent (Mid-Quarter Monetary Policy Review, September 20, 2013). Subsequently, he further hiked the repo rate twice consecutively to 7.75 per cent in the Second Quarterly Review of Monetary Policy in October 2013 and to 8 per cent in the Third Quarterly Review of Monetary Policy in January 2014. He made it clear at the beginning of his stint that nothing had changed in terms of thinking. The RBI under him is very much in sync and in continuation with his predecessor who raised repo 13 times in four years from 4.75 per cent in March 2010 to 8.50 per cent in October 2011.  As Shetty (2013) suggests, that was a hike of 375 basis points.

Recent thinking and policy stance of the central bank suggests that today there is greater faith in monetarism than in previous years. The RBI has formally announced it will pursue the single objective of inflation targetting, based on its belief that “price stability is a necessary precondition to sustain growth and financial stability” (RBI). The RBI, armed with the Urijit Patel Committee recommendations, has formally adopted the policy of inflation targetting as its single point objective. Following the Monetary Policy Framework agreement with the Government of India (on February 20, 2015), price stability is its core objective. The bank has fixed its medium-term inflation target at below 6 per cent (measured by the CPI-C) by January 2016 and 4 per cent (+/- 2 per cent) for the financial year 2016-17 and subsequent years. It is expected that the repo rate will be used as the predominant policy instrument in maintaining price stability in the Indian economy.

Low interest rate is required to enhance investment and the monetary policy must address this important issue as it plays a critical role in sustaining growth. The tightening of the monetary policy over the years has resulted in declining investment in India. In 2013-14, the Gross Fixed Capital Formation (GFCF) as ratio of GDP declined to 29.7 per cent in current prices, which is the lowest since 2005-06 (30.3 per cent, Economic Survey 2014-15). The decomposition of investment shows that, interestingly, it is private corporate investment that has been badly affected with the tightening of monetary policy. As per the latest estimate, private corporate investment has failed to even restore to its pre-crisis level
of investment.

Another important fact that is emerging in India is that the higher rate of interest is unable to mobilise higher savings. During the period of monetary tightening, with higher interest rates, the rate of saving has gone down to 30.6 per cent in 2013-14 against 36.8 per cent in 2007-08. The argument that higher interest rate resulting from monetary tightening would boost domestic investment through higher mobilisation of savings seems to have also gone the other way.

Monetary & Fiscal: Double Whammy and Resulting Confusion

As argued above, while the narrow objective of inflation targetting ignores several key policy objectives that are peculiar and significant to a developing economy like India, at the same time the central bank is still advocating stringent fiscal discipline and fiscal consolidation (Monetary Policy Report, April 2015). This doubly compromises the developmental needs of a developing country. Rather than addressing the pressing developmental needs, including social and infrastructure development and demand deficiency, the inflation targetting monetary framework seeks to make the fiscal policy subservient to the monetary policy. Instead of squeezing public expenditure in order to reduce fiscal deficit, efforts must be made to strengthen the revenue side of the government’s finances. There is ample scope for strengthening the Centre’s revenue, and side by side increasing the tax to GDP ratio, which has been stagnating for a decade or so. In recent years, the Centre’s tax revenue as ratio of GDP has declined to 7.2 per cent in 2013-14 (P) and 7.6 per cent in 2014-15 (BE). The low tax revenue to GDP ratio can be attributed to low revenue collected through the provision of direct taxes. The direct tax to GDP ratio has stagnated at around 5 per cent (gross direct tax to GDP ratio) since 2006-07.

On the other hand, there is too much dependence on indirect taxes which have direct implications for inflation. Various sources of direct taxes like wealth tax, capital gains tax, inheritance tax and so on must be explored so that revenue collection will increase and development expenditure will not be compromised. The Centre’s capital expenditure to GDP ratio has also gone down significantly to 1.76 per cent in 2014-15 from 3.5 per cent in 2004-05. While the positive growth implication of capital expenditure cannot be denied as a source of investment, there must be effort to improve the capital expenditure as it will improve the economic climate and better tax collection which may result in a further decline in fiscal deficit.

The monetary policy framework of the RBI not only seeks to make the fiscal policy subservient to it, it has recently announced a policy statement showing that it tends to influence the welfare-centric policies of the central government too. The June 2, 2015, policy statement outlines that the government should limit the increase in agricultural support prices (Para 8, Monetary Policy Statement, June 2015). The above statement not only reflects the lack of understanding of the RBI and of the ongoing crisis that the agriculture sector in India is facing; but the policy suggestion as stated above can be counterproductive from the perspective of agricultural production. As outlined in the Economic Survey 2014-15, Chapter 5, compared to last year, the production of food grain is likely to go down by 8.5 million tonnes (which was 265.57 million tonnes last year). The reduction in food grain production is likely to further fuel the food inflation in India. Ideally, the solution to this problem should be to increase production by providing various incentives to farmers and by removing  several other structural impediments like making provisions for adequate agricultural credit, fixing the support price which must correspond to the growing input cost, and so on. The suggestion by RBI would not only result in further reduction in food grain production, but it will also force the small and marginal farmers into a state of indebtedness. The increasing farmer suicides are already very alarming. With declining agricultural income over the years, one wonders how the RBI thinks it is addressing the agricultural crisis.

The impact and experience of such a monetary policy is also putting strain on the central bank’s focus to some extent. Some of the monetary policy statements issued by the bank present a confused picture. At one end, the bank presents a gloomy picture highlighting the factors responsible for building inflationary pressures – like a weak monsoon, volatile crude oil prices and geopolitical risks. On the other hand, it seeks to reduce repo rate by 25 basis points from 7.5 per cent to 7.25 per cent.

When asked by a journalist (page 8, interaction with media on June 2,  2015) to justify the rate cut by 25 basis points, especially in a situation where the RBI perceives that the inflationary forces are building up, the RBI Governor did not address the question satisfactorily but just suggested that it was needed to boost investment. This is precisely the point; it is expected from the bank that it would understand the limitations of the monetary policy and be willing to adopt an appropriate interest rate policy that will be conducive for growth and for worsening income distribution.  A policy that  is singularly focused on inflation targetting will benefit the speculators and asset holders the most, by protecting the real value of their assets, even when ordinary citizens suffer loss of jobs, worsening income inequality and a general slowdown in the economy.

Can the private sector give us a way out?

Often we are told that public policy need not play any role in boosting growth and investment directly. Let us put faith in the domestic and international private players. The faith in the private sector to boost investment and growth also appears misplaced. The share of priority sector advances in total bank credit has been declining, which is a cause for concern as access to credit for historically neglected sectors and weaker sections of society is declining. In the absence of any other credible sources of credit or finance, the decline in bank advances under priority sector will adversely impact the vulnerable sections. The bank advances under priority sector have declined from 44.7 per cent in March 2008 to 36.3 per cent in March 2013 and 39 per cent in March 2014 (Economic Survey 2014-15). It implies that there is a migration of credit to other sectors, which otherwise would have gone to the sectors falling under the purview of the priority sector. Another worrying aspect of the pattern of credit disbursement is that, as per the revised guideline issues in October 2012, the large size accounts have been included under the ‘priority sector’ category (Shetty, 2013). This revised guideline will dilute the purpose of the direct credit arrangements. 

The RBI is also trying to lure foreign players to boost the economy. In its Sixth Bi-Monthly Monetary Policy Statement in February 2015, the RBI proposed providing some protection to foreign investors against the downside risk (risks associated with losses) to attract more FDI. In consultation with the government, the RBI made provisions to introduce greater flexibility in the pricing of instruments/ securities so that the risks associated with the investment can be minimised (including an assured return at an appropriate discount over the sovereign yield curve).  Similarly, to facilitate foreign capital, the RBI in its monetary policy statement (Sixth Bi-Monthly Monetary Policy Statement, February 3, 2015) proposed (in consultation with the government) allowing the Foreign Portfolio Investors (FPIs) registered with SEBI (as long-term investors) to reinvest in government securities, even in scenarios of  full utilisation of existing limits.

On the one hand, the current monetary framework seeks to maintain higher interest rates through monetary policy that squeezes domestic investment; on the other hand, it seeks to facilitate foreign capital to maximise the benefit from it. The large-scale flow can have a destabilising effect in case of large-scale capital outflow following any hike in interest rate by the Federal Reserve. This strategy clearly has the risk of exposing India to destabilising tendencies inherent in the FPIs. The recently released data on foreign investment shows that the FII flow continues to be higher than the FDI inflow in India (Net FDI US$36.6 billion and Net Portfolio Investment US$41 billion in 2014-15).

The government still wants to put faith in global investors to kick-start the economy and boost investment. The central bank recently said it was committed to increasing the foreign investment ceiling on the government bonds, though it would be mindful of not over-relying on such investments. “We are committed to a steady expansion in the absolute value of FII (foreign institutional investor) participation, while ensuring we don’t go overboard and become overly reliant on FIIs for financing in government bond markets or corporate bond markets,” Rajan said at a news briefing after a board meeting of the bank.

Whose Interests: People for Creditors?

With the increasing financialisation of the world economy, inflation targetting monetary policy will be helpful only to the rentier’s interests. The developing countries are always under pressure as to how to satisfy their creditors so that the liquidity is maintained and their foreign exchange reserve not affected by capital flights. Therefore, from the domestic policy point of view, there is always a pressure to accommodate the demands of the creditors. This is what Epstein and Gintis call ‘International Credit Regimes’.

What is needed is that, instead of pursuing the single point policy objective of price stability, the RBI must broaden its monetary policy framework. It must balance the multiple objectives of growth, stable prices, external balance, income distribution and financial stability. The key to achieving these multiple goals is bringing to the forefront of policymaking the interests of the larger sections of society and not constructing a macro policy environment which caters to the interests of investors, creditors and speculators.

The limits to the efficacy of the monetary policy in containing inflation have to be recognised by the bank. Beyond the adverse consequences of pursuing the narrow objective of inflation targetting which has far-reaching implications for society and economy, technically a developing economy like India is perhaps not ready for this policy experiment. With the absence of a fully integrated financial market, the interest rate transmission channel within the inflation targetting framework will be weak and limited. This is quite evident from the fact that in India the impact of a monetary policy announcement is realised after a substantial time lag (a few months). So why conduct a policy experiment which is both not technically sound and not socially just?  

(Santosh Das is an Assistant Professor at the Institute for Studies in Industrial Development. Atul Sood teaches at Jawaharlal Nehru University, New Delhi)