How the RBI Burst India’s Bubble

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The RBI’s move to curb inflation by hiking interest rates 12 times in 17 months has not just backfired, but actually slowed down India’s growth engine

By Prem Shankar Jha

In whose interest? The paranoid fear of inflation has forced the government to obey the RBI’s diktat
In whose interest? The paranoid fear of inflation has forced the government to obey the RBI’s diktat
Photo: AFP

IT HAS been apparent to every businessman for more than a year that the spurt of growth that India experienced in 2009-10 is over. The only exceptions are the ‘policy entrepreneurs’ who serve the Indian government. Till as recently as a month ago, when the GDP data for the first quarter of 2011- 12 showed that the growth rate had slipped to 7.7 percent, Finance Minister Pranab Mukherjee was stoutly maintaining that India would nonetheless achieve 9 percent growth this year, and the Reserve Bank of India was saying that the economy would still grow at close to ‘the trend rate’ of 8 percent.

It finally took a foreign journalist to burst their bubble. James Lamont of the Financial Times reported that several economists had begun to voice fears that India could return to a ‘Hindu’ rate of growth. “Far from being in a pole position among emerging markets,” he wrote, “India trails in terms of attracting foreign capital and beating inflation. Senior executives complain bitterly about Delhi’s painfully slow or inconsistent decision-making. Many local companies are focussing their investments on Africa or Latin America.” Similarly, a senior executive of a Singapore-based investment company expressed his shock at finding that when he asked senior executives of Indian firms where his company could invest in India, they sought his advice instead on where they could invest in east Asia. The official growth figures were misleading, and the real rate of growth, in their opinion, was not more than 5 percent.

The hard data support this conclusion. According to the latest estimates, industrial growth has fallen from 9.7 percent in April-July 2010 to 5.8 percent this year. The decline in manufacturing has been even more steep, from 10.5 to 6 percent.

Sectoral growth rates are even more revealing. Growth in the capital goods sector fell from 23.1 percent in April-July 2010 to 7.6 percent this year. Growth in the production of intermediate goods, which is considered the most reliable indicator of future production, fell from 10.1 percent to 0.8 percent. If one looks closely at the data, one sees a pattern of recession spreading from the most interest rate sensitive industries outwards to the less sensitive ones. The real estate sector went into an absolute decline in the last quarter of 2010-11. Car sales have also slumped.

Surveys of industry’s future intentions are uniformly pessimistic. The purchase managers’ index has fallen continuously for five months and is close to 50 percent, which indicates zero growth. A massive postponement of investment is taking place: the latest survey of investment intentions by the Centre for Monitoring Indian Economy shows that these have declined by 55 percent over what they were a year ago.

The cause of this decline is only too well known: it is the 12 successive increases in inter-bank interest rates that have sucked vast quantities of money out of the credit market and pushed the base interest rate for borrowers up by 3 percent in the past 17 months. The irrefutable truth is that the RBI’s interest rate policy has killed off the huge surge of growth that the government’s fiscal stimulus packages of 2008 and ’09 had set off. If the decline in industrial growth has not been even more sharp, it is only because hundreds of companies have shifted their borrowing to foreign money markets where the rates, even after hedging, are a third of what they would have had to pay in India. The evidence is in the part of the RBI database that it chooses to ignore: the monthly table of external commercial borrowings of Indian companies. These have doubled from an average of $1.53 billion between August-November 2010, to $3.18 billion a month between December 2010 and July 2011. Over half of this money has been raised by a handful of companies investing in power, telecom, offshore oil development and steel — all highly capital-intensive industries with long gestation periods

This is not news to the government. So why is it acquiescing so tamely to the dictates of the RBI? The answer is its paranoid fear of inflation. The RBI governor has only had to say that curbing credit is necessary to bring down inflation, for the pundits in Delhi to fold their tents and slink away. What is less easy to discern is why it is allowing the RBI to continue having its way when it is as obvious as the nose on one’s face that the RBI has utterly failed to make any dent whatever on inflation.

The RBI is trying to fight inflation by killing demand for raw material and oil in India

Nor is this a new development. Public memory is short, so most of today’s critics date the RBI’s obsession with inflation to April 2010 when it made its first of 12 successive increases in repo rates to jack up lending rates and physically limit the supply of credit in the economy. But the RBI’s obsession with inflation can be traced back almost five years to a warning given by the then RBI governor, Y Venugopal Reddy, in December 2006 that inflation had crossed the safe limit of 5 percent and the economy was overheating. Weeks later, the RBI had announced the first of seven quarterly belt-tightening measures that took more than Rs 1 lakh crore out of the money market, raised the prime lending rate by more than 2 percent and chopped entire categories of buyers out of the credit market. Did it lower inflation? Judge for yourself: In 2006-07, when Reddy hit the pause button, inflation — measured by the wholesale price index — was just 3.5 percent. In 2007-08, despite four more hikes in interest rates, inflation nearly quadrupled to 12.1 percent.

The reason was obvious: Even in 2006, prices were rising not because too much money was chasing too few goods, but because of supply shortages that were pushing up the cost of food products and raw materials. This began in 2006-07, when primary product prices rose by 8.6 percent, accelerated in 2007-08 and then abruptly fell with the onset of global recession in late 2008. Inflation had stayed low in 2006- 07 because the government did not pass on the rise in fuel prices to the consumers. It quadrupled in 2007-08, when the government abandoned this effort and allowed prices to reflect the true rise in the cost of inputs. Inflation disappeared in 2008-09 because of a 35 percent fall in global commodity prices and a 70 percent fall in the price of crude oil. The RBI’s policies affected neither the rise nor the fall in the inflation rate by even one jot.

The same cost-push, supply-side factors are behind the inflation that returned in late 2009. Oil and raw material prices have risen because of shortages caused by soaring demand in China. But the RBI is trying to fight it by killing demand in India. Inflation has refused to budge and stayed close to 10 percent.

How does the RBI justify such rank folly? Like his predecessor, the current RBI governor, D Subbarao, has justified the rate hikes as necessary to curb “inflationary expectations”. But what are they? How does one know that such expectations have arisen and, more importantly, when they have been suppressed? The RBI has not identified a single yardstick by which to do so. Instead it has invited its opponents to prove a negative — that inflationary expectations do not exist. Proving a negative is logically impossible. The RBI is trumpeting this absurd proposal because it cannot admit the enormity of the damage it has done. Instead, it has questioned the reliability of the Central Statistical Organisation’s data on industrial slowdown, and the decline in employment in the unorganised sector revealed by the labour ministry.

The finance ministry too has chimed in by pointing to increases in advance tax receipts as proof that industrial production is not falling. But no amount of fiddling by Nero is stopping Rome from burning. The Sensex has continued its crawl downwards and is now below 16,000. Dussehra and the approach of Diwali have not given it even a flicker of temporary life. The prices of shares not included in the Sensex, and those of mid and small capitalisation companies have sunk. One result is that companies that issued convertible debentures abroad are now unable to redeem their pledge of conversion and are asking for a rescheduling of the conversion. India is, in short, facing its first ever private debt default.

Finally, one can only have the most unstinting praise for the RBI’s sense of timing. In 2008, it made the last of its interest rate hikes in the teeth of financial meltdown, only a month before the onset of global recession. This time round, it made its last rate hike in July in the teeth of a far more serious financial crisis in the US and the Eurozone and accelerated the flight of institutional investors from the Indian stock market. The resulting 10 percent drop in the value of the rupee against the dollar has changed what was to have been cheap credit into some of the most expensive credit in the world. And that is, literally only half of the story. For dollar debt accounts for only 54 percent of the total; 23 percent has been incurred in yen, pound and euro, all of which have appreciated sharply against the dollar. If the loss of confidence in India is not reversed, some of our largest and most respected companies will soon be in trouble.

Prem Shankar Jha is a senior journalist.
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