Blend Fiscal with Monetary Policy: Financial Express: 31st Jan 2008

Addressing inflation at this juncture may have been necessary but may not be sufficient

Against the background of the financial crises, stock market as well as subprime, there is a school of thought which believes that an economic slowdown is inevitable in the US. This is supported by an article in The Economist (‘Faulty powers’, January 26, 2008) which questions the potency of monetary policy in addressing growth under some circumstances, and, drawing from Alan Blinder’s findings (Centre for Economic Policy Studies, Working paper Number 100, June 2004), recommends the use of both fiscal and monetary policy to spur growth. The basic view is that when there is a crisis of credibility, which is neutral in response to interest rates and liquidity, banks just do not lend. Hence, from a stage during the boom when everybody was cheerfully lending money to everybody, today nobody wants to lend to anybody. This being the case, one needs to naturally look more closely at fiscal policy as a growth stimulus. In fact,
Mr Strauss Kahn, IMF’s new head, has done a volte-face and moved away from fiscal consolidation to “a new fiscal policy approach” based on pump priming.
Back home, the RBI Governor, Dr YV Reddy, has preferred to keep interest rates unchanged for ostensibly different reasons. He believes that Indian growth this year is doing fine at 8.5%, and the apparent slowdown in industrial growth is not real. In fact, it would come down further from the 9% plus levels as the year progresses, once the high base effect kicks in. With capital goods growing by over 20%, there is no reason to believe that investment has slowed down, which would have otherwise been a concern.
Now, back at Davos, P Chidambaram was gung-ho about tax collections, which have been growing thanks to better compliance and corporate performance (excise, customs and corporate tax collections). But he was not willing to promise tax relief in the forthcoming Budget because expenditure has also been going up, mainly on account of higher interest payments and subsidies. The reason is monetary, as the servicing burden of MSS bond issuance has grown heavier to stabilise the rupee. The FM also indicated a preference for lower interest rates, and normally one would have expected the RBI to follow such advice. Not doing so raises some fundamental questions.
The first is whether or not growth is an issue today. Going by the RBI, there is no growth problem. In fact, the system is flush with surplus liquidity, and if one wants to borrow, one can. Banks are giving in around Rs 20,000 crore daily via the reverse repo window. The government’s borrowing programme, meanwhile, is almost complete. So funds are there for the asking, albeit not any cheaper.
The second question is that if there are such surpluses, then why are they not being loaned? Banks are opting for government paper, which earn less even if they are risk-free (ignoring market risk). It is possible that banks are unwilling to lend—especially to the mortgage-dominated retail segment. But this is not really evident. Further, Companies are raising funds in the capital market and may not be interested in taking on bank debt. There may, thus, be a demand issue.
Any which way, the third question is why is it that banks are not lowering their interest rates, considering that based on the law of demand and supply, the price of capital should come down when supply exceeds demand? Banks always wait for signals from the RBI. If the RBI does not lower rates, they are unlikely to do so. But why should this be the case if interest rates are determined by banks on their own accord? If one looks at the banking structure, today the credit-deposit ratio is around 70%, and interest rates here are set by banks themselves. The RBI’s repo/reverse repo rates affect the banks only to a small extent. Instead, they have a heavy influence on the bond market, which affects the rest of the deposits, the 30%. This is how deposit and lending rates get aligned, even though 30% of funds should not be driving the rest, the 70%.
The last question is whether fiscal policy needs to be more proactive. This is debatable because in the last four years, the government has gone in for consolidation and not used the Budget as a means to stimulate growth. The time has probably come for fiscal policy to be used along with monetary policy to tackle the twin issues of growth and inflation. Inflation is latent today, given the policy of administered prices in key sectors, and hence monetary policy needs to be restrictive to eschew potential inflation. Until such impulses get absorbed by the system, fiscal measures should work alongside to help growth.
Rudimentary theory says that we need two instruments to tackle two problems. When it comes to inflation or growth, RBI has... to toss a coin and choose one of them—it’s inflation today. The Budget ought to address the other this February end.