"Is credit contraction a good Idea" Business Standard: 2nd February 2011

Is credit contraction a good idea?

Monetary tightening has done little to curb inflation and will hurt investment, but the credit surge suggests that inflation is demand-driven, so it’s better to have lower near-term growth than a hard landing later.
When monetary tightening is not really achieving the objective of lowering food inflation, it deserves to be reviewed given its deeper impact on the investment climate

The focus of the Reserve Bank of India ) so far has been to use interest rates as a tool to control growth in credit which has been steady this year. The idea, ostensibly, is to reduce demand-pull inflationary forces and rein in inflation. There are two thoughts here. First, whether credit contraction will deliver the result in terms of combating inflation. Second, whether this act, or rather series of acts, will affect the economy adversely in some other way.

The concern is palpable on primary product prices that have been fraught with output failure in non-conventional articles (beyond kharif which is doing well) like fruit, vegetables, dairy and meat products. Here, interest rates or liquidity do not really matter because raising repo rates cannot augment supplies and we will continue to pay higher prices until such time as supplies come in. There is little evidence of hoarding on the back of bank lending. Therefore, credit contraction will have a limited impact on inflation and a further tightening of strings will just not work.

To be charitable to economic theory, it may be said that credit contraction through higher rates will impact only demand-pull inflationary forces to the extent that they exist in our system. This will mean core inflation or “non-food, non-fuel, non-LME” inflation. But, most certainly it will not really achieve the desired objective of controlling the present issue of consumer inflation. The RBI may end up saying that the policy has worked, but really the retail prices of food would not be affected. The consumer price index (CPI) will continue to reflect the ground reality since the lower wholesale price index (WPI), due to declining prices of machinery or chemicals, does not affect us.

If this were so, the next question to be addressed is whether this move is a good idea especially since this measure will not be bringing down food prices. India is at a critical stage of growth where the push has been given during the global crisis years and the challenge is to maintain the momentum. Globally, central banks are easing interest rates and liquidity in a bid to encourage investment and consumption. Admittedly, monetary policy should be driven by domestic and not global factors, but if the objective of inflation is not really being achieved, should we be coming in the way of growth by tightening liquidity?

We have the curious combination of a high fiscal deficit and government borrowing, lower government expenditure and higher holdings of cash obtained through the 3G spectrum auctions, low growth in deposits, higher hoarding of currency by the public, and an industrial sector that is yo-yoing in terms of growth. Liquidity is an issue that is being aggrandised as banks are desperately borrowing Rs 1 lakh crore on a daily basis from the RBI. The wisdom of monetary tightening has to be questioned.

With the government having an edge when it comes to attracting banks in terms of investments in its debt, the private sector would be at a disadvantage with a shortage of funds and an increasing cost of credit. This will impact medium-term growth prospects especially when we need to have large quantities of investment in both industry and infrastructure. In fact, talking of infrastructure projects, those that are being undertaken will have their cash flows jeopardised since revenue streams are fixed over the tenure while costs would now be increasing due to higher interest payments. Therefore, there is a possibility of some adverse consequences here. Simultaneously, consumer spending on housing and automobiles will slow, thus weakening the backward linkages with industries that have been growth drivers in the past.

Keeping such a situation in mind, it does appear that when monetary tightening is not really achieving the objective of lowering food inflation, it deserves to be reviewed given its deeper impact on the investment climate. The RBI has also mentioned indirectly that it can do little more to ease liquidity with the Statutory Liquidity Ratio and Open Market Operations measures having limited impact. Under these conditions, it may be advisable to leave liquidity alone for sometime.