The fiscal and monetary moves slated for this week could end up defining this year's economic trajectory. The reference, of course, is to the Budget and RBI's monetary review. The RBI has already made its move with a 75 basis point CRR cut; however critical action is needed now on the interest rate front.

The government should cut back on its ultra-loose fiscal policy stance by bringing expenditure under control. Perhaps, that is too much to expect from a besieged government, but it is what is needed to rejuvenate the faltering Indian growth engine.

The RBI has already cut the CRR by 125 bps in the last two months. Let's put into perspective how grave things are. A CRR cut of this magnitude or more has been witnessed only twice before in the past decade — once during 2001 post 9/11, and the second during the financial crisis of 2008, after the Lehman collapse.

There is certainly some element of seasonality to the liquidity problem. But what should not be missed are two serious structural underpinnings — slowdown in private sector credit growth, and slowdown in the growth of forex reserves in the past two quarters.

Disturbing trend

Ever since the end of the financial crisis of 2008, private credit growth started to recover, but this was accompanied by an increase in the government credit growth as well.

On earlier occasions, whenever private credit growth would take off government credit growth would taper away, thus enabling the country to tread on the path of high growth with moderate inflation (the golden period from 2003-2007 as can be seen in the graph).

However, post 2009, both private sector and government sector credit have seen a rapid increase, unforeseen in the last two decades. Government credit growth has largely been as a result of its redistributionist policies that are causing serious misallocations of capital, without having much of an effect in increasing the real supply, thus reducing economic productivity. This has resulted in near double-digit inflation for the past two years.

The RBI tried to rein in this unabated credit growth, and thus inflation, with an increase in interest rates. Unfortunately, the fiat monetary system that we are living in is like an inverted pyramid, which implies that even a moderate slowdown in the credit growth can cause severe stress in the system. So, as a result of the increase in the interest rates by the RBI, the private sector credit is only expected to grow by 16 per cent this fiscal, compared with 21 per cent last year, making it harder for the borrowers to service the debt and thus contributing to the liquidity stress. But at the same time, government credit growth, which is the real source of inflation, continues unabated (it is expected to be around 25 per cent this year).

Three-tune symphony

The slowdown in forex inflows in the last year, and the severe fall in the rupee that made the RBI intervene in the forex markets, has been another source of stress in the system. It has led to a slowdown in the increase of base money. The only way to get out of this mess and at the same time to keep a lid on inflation is for the country to play a three-tune symphony — by again attracting substantial forex inflows, especially in the form of FDI, reducing government expenditure and increasing private credit growth.

On the fiscal front, it is critical that the government, in this Budget, presents a credible plan to cut down on its expenditure, and at the same time shows its resolve to improve the investment climate, thus attracting forex inflows. This would help improve the stock of base money and maintain the value of the rupee.

On the monetary front, this should be accompanied by rate cuts by the RBI. This would translate into higher private credit growth and higher growth rate, thus relieving the stress in the system.

(The author is an independent financial consultant at Random Chalice Financial Research, Delhi. Views are personal.)

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