No Budget in free India has been awaited with as much hope and anxiety as the one Finance Minister Arun Jaitley will present on 10 July. Narendra Modi and the BJP were not elected on a Hindutva agenda. The 75 percent increase in its share of the vote — from 18 percent of the votes polled in 2009 to 31 percent this year — came because people across the country believed him when he said that he would do for India what he has done for Gujarat. And they placed their faith in him because the Congress had destroyed their future. This is the faith that Modi cannot afford to betray.
I have grown tired of repeating, ad nauseam, the warning signals emanating from the economy that the UPA government chose to ignore, and the financial media to underplay. But the reminder is necessary because in the lead up to the Budget, the government is again being inundated with advice from the very people who paved the way to industry’s collapse and the UPA’s rout.
These advisers, many of them self-appointed, told the Congress party chief Sonia Gandhi that fighting inflation had always to take priority over stimulating growth. Growth benefited only new job seekers but inflation antagonised everyone. Narasimha Rao’s government, they pointed out, was voted out in 1996 because it had allowed inflation to enter double digits in 1995. If her government did not maintain stable prices, it too would suffer the same fate.
The UPA heeded this advice. It went on an interest rate hike spree in 2007 and 2008, and may well have persisted had the global recession in 2008 not brought all commodity prices down by 60 to 70 percent. This stopped Indian inflation dead in its tracks and was the first, unmistakable, sign that India was no longer a closed economy in which inflation was caused solely by excess government spending or a bad harvest, but was now vulnerable to commodity price changes across the globe over which it had no control.
But this lesson was lost upon the UPA’s advisers and policy makers, so when inflation again went into double digits in March 2010 on the back of surging international commodity prices caused by a huge investment spree in China, they once again opted for a succession of interest rate hikes to curb demand in the Indian market. These had absolutely no effect on the rate of inflation (measured by the cost of living) but pushed up lending rates to between 12 and 16 percent.
The effect on the economy was catastrophic: the construction industry went into a coma; the purchase of consumer durables dropped sharply; and the automobile industry, which had led the surge in growth since the 1980s, went into an absolute recession from which it has still not emerged. Overall industrial growth fell from a hectic 13.5 percent between July 2009 and June 2011, to minus 1.9 percent between April and December last year. Since October 2011, industry has been dead in the water, with its average growth close to zero. Not surprisingly, therefore, employment growth has also stalled. Close to 40 million young people have entered the labour market in the past four years, only to find that they have no future.
Tens of thousands of small- and medium- sized enterprises have quietly folded, pulled down their shutters and declared themselves bankrupt. Since the private banks regularly cherry-pick the most promising investments, the bulk of the increase in non-performing assets has been in the public sector banks. Today, it is these that the advisers are suggesting be ‘refinanced’, i.e., sold.
Even ‘blue chip’ companies are in mortal peril. Encouraged to borrow abroad by the skyrocketing interest rates in India and all-time low interest rates abroad, they have been caught flat-footed by the 40 percent fall in the value of the rupee since September 2011 and are finding it hard to service their debt. As for the 200 or so companies that had issued convertible debentures abroad in the palmy days of hectic growth, the collapse of share prices has forced them to postpone the conversion again and again.
Despite the mounting evidence of failure, for four years a government packed with economists from Cambridge, Oxford and Chicago, continued to pursue policies that it could see were not having the slightest effect on prices, but only killing industry. And still they persevered, until the people had to kick them out in a quiet frenzy of revolt.
But the UPA’s erstwhile advisers have learned nothing and forgotten nothing. Today, the very same people are giving the Modi government the very same advice that brought the UPA to disaster. In its transition notes for the new government, the PMO emphasised the need to bring inflation under control first. Crisil, India’s premier rating agency, also urged the new government to put price stability before growth and warned it against expecting an industrial revival in less than three years. The Economist patronisingly advised Modi to re-finance and reform (which means sell off) the public sector banks and keep Raghuram Rajan as RBI governor because inflation was partly the reason why the UPA lost the elections and ‘Rajan is doing a good job’.
Rajan himself did not think he was trespassing on New Delhi’s prerogatives when, asked about the possible impact of a poor monsoon and the turmoil in the Middle East, he stated that an interest rate cut was unlikely to take place in the next few quarters.
One can only hope that Modi is listening to industrialists more than economists, but if he is tempted to do the latter, he needs to ask them how he will fulfill the promises he has made to the people. He has promised India good roads, high speed trains, modern ports and an end to endemic power shortages — in short, a world-class infrastructure. All these will require heavy capital investment, and have long gestation periods. Who, he should ask himself, will take these up if he has to pay interest rates of 11-12 percent a year?
He has promised to revive industrial growth, but between a quarter and a half of industrial output consists now of consumer durables and construction materials for homes, offices and factories, purchased through instalment payment plans. How many people will be prepared to take loans at such high rates of interest?
The Indian economy does need a host of deep-seated reforms to sustain rapid growth, that range from reducing the fiscal deficit to ending the license-permit raj and obtaining land for development projects without having to fight the poor. But economic growth has to be revived first in order to be sustained. And this cannot be done without first lowering interest rates drastically.
Modi faces this task with one inestimable advantage that the UPA did not have. He belongs to a political party that has already pulled India out of recession once in 2002. There are people in his party who remember how it was done. Bimal Jalan, the RBI governor at the time, who orchestrated a halving of interest rates between 2000 and 2002, is a member of his party. One can only hope that Modi and Jaitley will draw upon their experience as they frame their policies for the future.
What needs to be done
Some questions and answers on how the government can kickstart economic growth:
How can the Indian economy return to its high growth rate of 2003-11?
Lower the repo rate from 8 to 5 percent. Lower the cash reserve ratio to 3.5 and later 3 percent.
How will this help?
It will revive industrial growth in three stages:
First, it will bring the reverse repo rate — the rate at which banks lend their surplus money to the Reserve Bank — down from 7 to 4 percent. This unappetising return on what is now considered a risk-free way of parking some of their deposits, will force commercial banks to lower their lending rates to the commercial sector. To do this, they will have to lower the interest rates they offer to their depositors.
Second, lower interest rates on bank deposits will start a shift of personal savings from banks, and from the bond market, to the share market. That will push up share prices, and set off a virtuous cycle. Rising share prices will pull more and more Indian and foreign capital into the share market. The rise will, therefore, continue until a new equilibrium level is reached. Higher share prices and lower interest rates will lower the cost of investment and set off an investment boom. At that point, the recovery of the economy will become automatic. Judging from past experience, economic recovery will take not much more than a year to set in.
Third, lower interest rates will revive demand for consumer durables, which make up 25 percent or more of industrial production. They will, therefore, revive industrial growth. Lower interest rates will also revive the demand for housing and office space. This will revive the construction industry — the largest employer in the country.
Will lowering interest rates and increasing money supply not cause inflation to rise further?
No. According to the strict Milton Friedman model, an increase in money supply raises prices directly only when industrial capacity is being fully utilised, and when there is close to full employment in the economy. This is not the case in India. As the RBI’s last Macro- Economic and Monetary Developments Report conceded, there is a 40 percent excess capacity in industry today. There is also no shortage of labour because 35-40 million young people have joined the work force in the past five years and are still looking for jobs. So industrial production can, and will, rise without any impact on prices.
In India, the inflation we are suffering from is being caused by shortages in supply, not an excess of demand. These shortages are both global and domestic. Global shortages are reflected in rising commodity prices, notably of oil. These have been the main propellants of inflation in the past five to seven years.
We also have local shortages that are driving up the cost of living, i.e., the retail price index. These are, however, largely of our own making and can easily be rectified. Cereal prices have remained high because of excessive procurement. There is at present a 50 million tonne excess of foodgrain stocks with the Food Corporation of India (FCI) over the country’s buffer stocking requirements, throughout the year. Some of this, particularly the wheat, is slowly rotting. Cereal prices can be brought down and stabilised at a lower level if the FCI indulges in open market operations — releases a basic amount, say one million tonnes, into the market every month during the intra-harvest periods, plus or minus the amount needed to keep prices stable. And it can lower and stabilise vegetable, particularly onion, prices by first sequestrating the amount needed to meet domestic demand and allowing only the export of the surplus. For 10 years, the UPA government has done the opposite. Onion prices, in particular, are so high and so unstable because it gave systematic priority to fruit and vegetable exports over domestic consumption. This may be okay for Alphonso mangoes, but it is a crime when it is done to onions, which are the most important source of iron and other nutrients for the poor. Sharad Pawar, who was the UPA’s agriculture minister, is one of the largest onion exporters in the country!
But wouldn’t a rise in the demand for manufactured products increase imports? Can India’s foreign exchange balance take the strain?
Past experience has shown that there is a bulge in imports, but it is usually followed by a rise in exports about 3 to 6 months later. India is well placed to absorb the bulge. After it took steps to curb gold imports last June, its balance of payments deficit on the current account in the next half year has fallen to just over 1 percent of GDP, from 4.7 percent of GDP in the previous fiscal year (2012-13). The reduction in the balance of payments deficit, together with the fresh inflow of foreign capital into the share market, will comfortably absorb any increase in the trade deficit. However, to ensure that exports rise, it is essential to not allow the exchange rate to appreciate below 60 to the dollar. The balance of the foreign exchange inflow must be impounded and added to the reserves. The new government’s goal should be to raise the reserves to $1000 billion in two years. We have been stuck at $300 billion for five years, and this is no longer a safe margin.
The RBI governor has repeatedly justified raising and keeping interest rates high on the grounds that although the wholesale price index inflation has come down, retail price inflation remains around 10 percent. Shouldn’t the government bring this down first?
The retail price (cost of living) index is a very bad index to peg interest rates to. This is because it can be pushed up or down by a host of developments over which governments, and Central Banks, have no control. Among these are international oil prices, international raw materials prices, a monsoon failure, freak localised rains (like the ones in Nasik district in November 2010, which destroyed 40 percent of the onion crop), a war somewhere in the world, an earthquake, a drought in Australia that destroys the rice crop, and so on. If you raise interest rates every time something like this happens, you bring an element of unpredictability into your equities market that makes the risk of investing in it unacceptably high. Every increase in interest rates brings share prices down because it shifts some money out of the share market into either the bond market or bank deposits. So share prices fall. If you cannot ever predict how share prices will behave, then you will avoid investing in them. That is what happened from August 2011 onwards, when the RBI turned a deaf ear to industry’s frantic appeals for a cut in interest rates.