The defining characteristic of the Indian economy now is its slide into stagflation — the combination of sliding aggregate economic activity (measured by GDP) and high and stubborn inflation.

Stagflation is probably the most difficult problem for economic policymakers to tackle.

Globally, the best example of how a country tackled and cured stagflation is available from the US experience of 1979 to 1982.

Like in India now, US GDP growth was first volatile and then decelerated sharply while consumer inflation rose to double-digits through the course of the 1970s.

Liquidity tightening

The policy medicine involved the central bank (Federal Reserve under Chairman Paul Volcker) creating extreme financial liquidity tightness and pushing interest rates up sharply.

The administration of that monetary medicine for some three years worked, and the US then embarked on a stable, relatively high economic growth path for the next two decades — that period of stable, robust growth with low inflation was interrupted only by the dotcom crash of 2000 and the relatively mild recession it caused.

With a good monetary policy framework in place, the stock market crash of 2000 caused only a mild recession. Also, the 1997 turbulence in the financial markets (Asian/Russian financial crisis) caused only a brief scare.

Pain unavoidable

The US experience shows that near term economic pain may be unavoidable to sustain-ably cure stagflation.

Absent such action, economies are likely to function in a sub-par manner and bounce along in a volatile manner with significant levels of imbalances/disequilibria.

In India, the Reserve Bank of India is nowhere near attempting what the US Fed did in the 1979-1982 period.

(It is interesting to note that prior to 1979, the US Fed also advanced the same arguments the RBI has been making in recent years, washing its hands off inflation containment — note the hair-splitting about core and non-core inflation, supply-side causes, weak monetary policy transmission, and so on).

This reluctance to act poses the greatest threat to India’s medium term economic growth prospects as it endangers financial system stability.

Weak real economic activity but high consumer inflation means that financial institutions will face problems on both their asset and liability sides.

Asset quality will be weak and asset growth volatile with no relief on the funding side too.

Clear evidence of this unbalanced operating environment for financial services businesses has been available in the past few years.

CPI bugbear

Though inflation measured by wholesale prices has declined in recent months, consumer price inflation continues to be in double-digits and households’ inflation expectations are also well-entrenched in the double-digits range.

As financial institutions render services to the retail market, it is only consumer price inflation — which retail households face on a day-to-day basis — which is the relevant inflation measure for assessing the impact of inflation on the financial services business.

That consumer price is the inflation measure most relevant for financial institutions is also borne out sharply by the sustained deceleration in the deposit growth of the banking system in the past few years.

With the rates on offer way below the level of prevailing consumer inflation, the pace of banks’ deposit accretion has been steadily declining.

That deceleration has resulted in an overall wedge developing at the systemic level between deposits and credit growth of some five percentage points.

The longer this gap is not closed, greater the chances of disorderly corrections coming about in the broader economy.

This structural funding gap has been continuously — in the past several years — made up by large daily borrowings from the Reserve Bank of India.

By providing large liquidity support to the banking system on a daily basis, the RBI is preventing banks’ deposit rates from reacting to the funding deficiencies in the only manner they should — going up.

The RBI therefore accentuates the underlying problem — which is that rates on deposits are out of line with the underlying retail inflation pressures and consequently deposits growth in the banking system is sliding.

The continuation of this trend poses the biggest threat to financial system stability. If the weaknesses in banks’ balance-sheets are addressed in time, the system as a whole may be able to avoid a forced and sharp ratcheting up of interest rates.

The longer it is postponed, greater the likelihood of disorderly corrections in the financial markets — stocks, currency and bonds — and sub-par performance of the broader economy.

(The author is a Chennai-based financial consultant.)

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