Memo to RBI: Only shock therapy will work from now on

When Reserve Bank Governor D Subbarao takes a view on interest rates next week in his mid-quarter monetary policy review, he should know that no matter what he does, growth will not revive and inflation will not come down.

Unless he decides to go in for shock therapy, which he has been loath to do so far. If anything, he has been willing to wound, but afraid to strike.

And by shock therapy we mean he should either cut rates significantly, or do the opposite - say, by, one or two percentage points immediately. This would be shock therapy, not a 25 basis points cut or status quo on repo rates. That would be neither here nor there.

The problem is that Subbarao has not been running a tight enough policy. AFP

For a frog sitting in water, if the heat is raised a little bit at a time, it is likely to get comfortable with the slowly rising heat till it reaches the level where it cannot survive. It would have been far better to give the frog a sudden jolt of scalding heat so that it would have jumped out when it could have saved itself.

India's wounded economy is suffering from a debilitating inertia that is neither too hot to jump off, nor hot enough to kill. But the end result is surely going to be a dying growth cycle- as the 5.3 percent GDP growth in the second quarter of 2012-13 testifies.

Subbarao's critics, who want interest rates brought down to reverse the slowdown, point out-not unfairly-that his tight money policy is not really working since there is no appreciable decrease in underlying inflation.

The Governor's backers-who include most global research agencies and right-wing economists-say the problem is that Subbarao has not been running a tight enough policy, and inflationary expectations are still nowhere near topping out. So he should not be sending a cheap money signal.

India's top moneyman has been equivocating between whether he should target growth or inflation over the last few quarters, but on balance he has managed to do little about either because monetary policy is ineffective when fiscal policy is pulling in the other direction.

So what's going wrong? Why hasn't the good doctor's medicine-holding the line on interest rates-cured inflation? And what does this tell us about what he should do next?

The most important element in cure is diagnosis. If your diagnosis is right, the cure will be obvious. If it's wrong, no cure is possible.

So the focus has to be on diagnosing right. A Seshan, writing in Business Standardtoday, offers an interesting insight on the diagnosis and says the problem is "inertial inflation" - a situation where inflation has stabilised at an uncomfortable level and refuses to be tamed. Others have called the phenomenon by a different name-structural inflation-but it's probably the same thing

And why has this happened in India? Seshan sees inflation as sticky because several expectations are built into the economy. He writes: "Inter alia, the factors that contribute to it (inertial inflation) are the annual increase in support prices for agricultural produce that provide the benchmarks for the markets, the periodical wage revisions in the organised sector and RBI's assumption of an 'acceptable' inflation rate of four to five percent -which people know by experience will be exceeded. The central bank can deal with only the last factor in relation to expectations."

Jahangir Aziz of JP Morgan Chase, writing The Indian Express, explains the other side of the inertia by pointing out that despite high rates, "India has not even enjoyed the 'benefit' of lower inflation from falling growth. Instead, inflation has remained stubbornly high. The authorities and many in the market have raised this as a puzzle. But there isn't one. India's growth has fallen from 9 percent to 5 percent not because of slowing consumption but because corporate investment has declined sharply."

Between Seshan and Aziz we have the real issue: the system is too geared for higher inflation, and the confidence to invest-which holds the key to supply side nirvana-is missing. Thus, we have a situation where lack of investment and growth is making fighting inflation even harder.

The way out of this "inertial inflation", or "inertial slowdown" is that we need a systemic shock, and Seshan's own suggestion is that the government should release its massive food stocks to the poor and lower the general level of inflation. Though this would not bring down the fiscal deficit (another important reason for "inertial inflation"), small-scale tinkering with the deficit is not achieving anything anyway. A plus point with this proposal is that politicians would be thrilled to give away grains at throwaway prices in an election year.

Aziz's shock therapy would include important second generation reforms like the introduction of a goods and services tax (GST). In addition, "I would place a permanent fiscal responsibility act that commits the government to hard budget constraints, a framework to price natural resources transparently, a land acquisition framework that balances the interests of sellers and buyers and a transparent set of election finance rules very high on that agenda."

A government married to two political rivals in Uttar Pradesh-Mayawati and Mulayam Singh-may not find the gumption to act boldly, but that still leaves RBI Governor Subbarao free to act.

What can Subbarao do in his 18 December monetary policy? What shock can he deliver?

Two possible shocks are possible. Since everyone is expecting a 25 basis points cut in repo rates, it is impossible to shock anyone with this. Since no one would be surprised if he held rates, this too would not come as a shock.

A true shock would have to be something higher on the Richter scale: if Subbarao thinks growth needs a kickstart, he should cut rates sharply-by one or two percent at one go. If he thinks inflation is the problem, he should raise rates by the same amount. The latter may worsen growth, but it could prod the government-our frog -to jump out and try out some second generation reforms.

The India Growth story is dying. It will survive only if there is a shock to the system. Over to you, Dr Subbarao.

Published Date: Dec 10, 2012 02:31 pm | Updated Date: Dec 20, 2014 02:37 pm

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