A confluence of factors — such as anaemic industrial growth, stubbornly high prices, a vulnerable external sector, deteriorating fiscal situation and, above all, political gridlock — has led to a deceleration of growth in the second quarter of 2011-12 to below 7 per cent.
Given this state of macroeconomic affairs at home and uncertainty about stability of the Euro, what should the monetary policy response be on December 16?
NATURAL RATE OF GROWTH
RBI has been maintaining for quite sometime that some growth needs to be sacrificed for bringing down inflation from persistently high levels. In its attempt to control inflation, RBI has raised the repo rate by 13 times since March 2010.
That the cumulative effects of past policy actions are working their way to slow down demand is visible from the deceleration in GDP growth from 7.7 per cent in Q1 to 6.9 per cent in Q2 of 2011-12.
Is this the ‘sacrifice' that RBI was looking for, or is it looking for further sacrifice to dampen inflationary pressures decisively? How major has been the sacrifice of growth would depend on an assessment of the maximum possible growth rate of GDP for India without creating inflationary pressures, popularly known as the natural rate of growth of the economy.
The natural rate of growth can differ depending on the methodologies used. A simple way of looking at the natural rate of growth is to consider the average sectoral growth rates and sector shares in GDP growth in the past eight years. This yields a GDP growth of close to 8 per cent.
If we consider 8 per cent as the natural rate of growth, we have given up 0.3 per cent in Q1 and more than 1 per cent of GDP in Q2 of 2011-12 in our attempt to control inflation.
The most worrying part of the Q2 GDP numbers is negative growth of capital expenditure. Unless the decline in capex growth is reversed, it would result in sub-7 per cent growth for quite sometime.
While raising the repo rate in the second quarter review on October 25, the RBI Governor had already indicated that the peak of the interest rate cycle had been reached and if there were no major surprises on the global or domestic front, there would be a pause.
The issue at hand is when to begin the the process of easing interest rates. Given the present state of sentiments, unless a course reversal of interest rates is made soon, the extent of sacrifice will only increase during the remaining months of 2011-12. In fact, it is not clear what is the natural rate of growth that the RBI has in mind.
While formulating its policy for the upcoming review on December 16, the central bank is confounded with two additional problems. One is to prevent the slide of the rupee and the other is to address the liquidity deficit in the system. While the decline in capital flows to India has led the depreciation of the currency, additional government borrowing has created a liquidity shortage.
There have been suggestions from some quarters for a cut in CRR (cash reserve ratio) to address the liquidity shortage. A cut in CRR, a blunt instrument in RBI's view, would negate its contractionary monetary stance; besides, the RBI has already infused Rs. 25,000 crore between November 24 and December 8 by purchasing government bonds.
The RBI's choice of open market operations over a reduction in CRR needs to be appreciated, as there is already a monetary easing bias owing to the depreciation of the rupee.
Wavering capital flows have the potential to put the currency under pressure. The downward movement can lead to a run on the currency as a self-fulfilling prophecy by the combined actions of currency speculators and exchange earners. Both, posturing and timely intervention can play an important role in managing currency expectations. RBI will have its task cut out not only to manage inflationary expectations, but also exchange rate expectations.
CRISIS OF CONFIDENCE
From a larger perspective, the moot point is to revive confidence in the Indian economy through growth-enhancing policies. The government is not being able to put through important reforms. With the government not living up to the expectations of the market, the RBI is now left with the larger responsibility of instilling confidence in the India growth story. Theoretically speaking, when confidence in an economy hits a low, monetary policy can be effective if corrective action is taken at an early stage, as opposed to intervention later. It is said that monetary policy can't pull an economy out of recession, but it can do enough not to aggravate the recessionary impulses.
Given the structural characteristics, India is perhaps entering a ‘new normal' combination of growth and inflation of 7 per cent and 8 per cent, respectively. Even to get to this new normal combination, it would serve the economy well if RBI charts out its rate-easing path sooner rather than later.
(The author is Associate Professor, Xavier Institute of Management, Bhubaneswar. The views are personal.)