Modi faces trial by fire in fixing the economy


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Narendra Modi has been swept to power by a wave of hope larger than any that India has ever witnessed before. Never before has any party obtained an absolute majority in Parliament without winning at least 40 percent of the vote. The BJP has broken this barrier decisively by winning 52 percent of the seats with just over 30 percent of the vote in the 2014 General Election.

Modi is conscious of the trust the people have placed in him. And so far, he has not set a foot wrong. He has set up a relatively small ‘super Cabinet’ to manage groups of complementary, or interrelated, ministries and, by inviting Sri Lankan President Mahinda Rajapaksa and Pakistan Prime Minister Nawaz Sharif to New Delhi for his swearing-in, along with other SAARC heads of government (as well as Afghanistan and Mauritius), he has sent out an unmistakable message that the Centre is back in control of foreign policy, and that it is the parliamentary and not the organisational wing of the ruling party that will control decision-making.

But Modi’s sternest test lies ahead. For the total loss of faith in the Congress that brought the BJP to power in this unprecedented fashion arose from the collapse of the economy in 2011. Today, industrial growth has fallen from 14.5 percent in 2009-10 to minus 1.9 percent; hundreds of large companies are deeply mired in foreign debt, tens of thousands of small companies have gone bankrupt and there are no jobs being created.

Modi’s first and most pressing task is to revive the economy. But how, and how soon, can this be done? He is already being deluged with suggestions and everybody is telling him that it will not be easy and will take time. Even before he assumed office, the PMO had produced a paper suggesting that his main task will be to control inflation, after which growth would take care of itself.

Outside the government, notably in the financial sector, most analysts have already explicitly rejected the possibility of a sharp bounce back. In a recent report, India’s premier rating agency CRISIL has concluded that the Indian economy has only “an even chance” of growing at 6.5 percent a year over the next five years. Its five-fold prescription is to tame inflation, further cut down the fiscal deficit, revive the commercial banks’ capacity to lend by improving their asset quality and re-capitalising them, encourage debt markets and, almost as an afterthought, boost manufacturing and employment.

If Modi accepts these gloomy predictions of growth and heeds the advice to tame inflation first, he will be doing exactly what his predecessor, Manmohan Singh, did and will meet the same fate. The truth is that it is economists, spouting the mantras of the Chicago School, and tied at the umbilicus to the banks that brought the world to its present sorry pass, who are mostly (albeit not only) responsible for the collapse of the Indian economy. For they provided the twisted logic that said that the way to deal with a slowdown in growth is to raise interest rates ever higher and crush demand.

In truth, the only way, absolutely the only way, to revive the Indian economy is not to crush but boost demand. And the quickest and surest way to do this is to lower interest rates. This is not a novel suggestion. Recent economic history is replete with examples of such covert success. In July 1983, when the US and Europe were in the throes of recession and monetarism was the prevailing religion, US Federal Reserve chairman Paul Volcker quietly abandoned it, and halved Federal Reserve benchmark rates. As Nobel laureate Paul Krugman wrote a decade later in his book, Peddling Prosperity, this began the US economic recovery that went on, with one brief blip, until the end of the 1990s.

A more pertinent example is the then prime minister Atal Bihari Vajpayee’s and RBI governor Bimal Jalan’s decision to halve interest rates between 2000 and 2002. This took only a year to kickstart the economic boom that lasted until 2011.

There is no single-point plan for starting an economic recovery now, but one thing is beyond any doubt: nothing will work unless it is prefaced by a sharp fall, preferably by half, of prevailing interest rates. Industrialists have been asking for this until they have become blue in the face. But the government’s and the financial sector’s economists have developed a battery of seemingly plausible economic reasons for not doing so, until inflation has first been tamed.

Here are answers to some of their most frequently advanced objections, in a simplified, question and answer form:

How can the Indian economy return to its high growth rate of 2003-11?
Lower the repo rate from 8 percent to 5 percent. Lower the cash reserve ratio to 3.5 percent 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 RBI — down from 7 percent 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 macroeconomic and monetary developments report conceded, there is a 30-40 percent excess capacity in industry today. There is also no shortage of labour because 35-40 million young people have joined the workforce 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-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 fruits and vegetables 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. The outgoing agriculture minister Sharad Pawar 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 three-six months later. India is very 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 to appreciate below Rs 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 foreign exchange reserves to $1,000 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 events 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 Nashik district in November 2010, which destroyed 40 percent of Maharashtra’s 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. For 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 into 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 the industry’s frantic appeals for a cut in interest rates.

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