There seems to be no end to bad news on the economic front. Industrial production fell by 1.6 percent in May. Exports fell by a much larger 4.36 percent in June. With the start of business on 15 July, another rush developed on the dollar, forcing the Reserve Bank of India (RBI) to raise interest rates to stem the outflow, even though it knew that this would push up the cost of borrowing for domestic investors by another unbearable 0.5 percent. RBI Governor D Subbarao may not be aware that he is retracing precisely the steps that the Thai central bank took in the months before the 1997 East Asian crash.
This bad news comes at the tail end of a host of other portents that are so bleak that they have bled every ounce of complacency out of the RBI and the finance ministry’s earlier forecasts. Industrial growth has not only slumped below zero this month; it has been below one percent for the past 20 months. Within industry, it is the most modern sectors, those whose growth potential is highest, that have been hardest hit. The automotive sector, which accounts for a quarter of consumer goods sales today, has recorded a decline of 6-8 percent in the past year. Passenger car sales have fallen 9 percent. The production of consumer durables has fallen by a whopping 10.4 percent. And the output of capital goods — the sinews of India’s future — is now 15.2 percent below what it was in April and May last year. Today, it is hard even to remember that at the bottom of the recession of the late 1990s, the sales of the automotive sector were still rising at between 10-20 percent a year.
The worst news is something that no one wants to hear. In the past five years, employment in the non-agricultural, unorganised sector has grown by 2.3 million, i.e., less than 0.2 percent a year. In the previous five years, it had grown at close to 5 percent a year. This means that approximately 34 million young people, who would have got jobs in the unorganised sector had growth not stalled, are now on the streets.
One does not even have to be an economist to conclude that the cripplingly high interest rates that the RBI has imposed upon the country ever since March 2010 are responsible for industry’s collapse. Other central banks, which also insisted that their governments should first reduce their fiscal deficits before trying to revive their economies, have learned the error of their ways. For example, the Japanese economy has only begun to revive after the latest of a succession of prime ministers brought interest rates down sharply a year ago. The International Monetary Fund has changed its tune and is screaming “reflate”. But the RBI seems impervious to change because, a day after the release of the data on industrial production, Subbarao announced that since consumer price inflation was still running at 9.97 percent, he would continue to give priority to containing inflation over reviving growth. In other words, there would be no significant cut in interest rates. With this statement, he doused the last flicker of hope that had been keeping share markets alive in recent weeks.
The consequences of his statement did not take long to surface. On 15 July, the second working day after Subbarao made his statement, a renewed rush to change rupees into dollars forced him to raise a key interbank lending rate by a full 2 percent in a desperate bid to stem the tide. He did so in the full knowledge that this would force banks to raise their domestic lending rates by another 0.5 percent.
Of course, the RBI denies that the flight from the rupee has anything to do with its monetary policies. According to Subbarao, it has been caused by the deepening global recession, which has severely hurt exports and increased the current account deficit to a hitherto unscaled 6.7 percent of the GDP in October to December 2012. Along with the UPA government’s chief economist, Raghuram Rajan, he has also blamed much of the recent fall upon the US ’ June 20 announcement of the end of its fiscal stimulus programme, which has increased the lure of the dollar.
But only those who are content with superficial explanations and disingenuous placebos will be taken in by these excuses. The global recession has been deepening gradually for the past five years, so the fall of the rupee should also have been gradual. But a close look at daily and monthly rates over the past three years shows that all of the depreciation since 2011 has taken place in two short bursts, and that both were triggered by RBI announcements, which took investors by surprise and eroded their confidence in the soundness of India’s monetary policy.
The first rapid slide of the rupee began immediately after the RBI raised interest rates in its July 2011 first-quarter policy review. The decision was perverse, to say the least, for by then no amount of self-deception could hide the fact that the Indian economy was sliding into a recession. Industrial growth had collapsed from 8.2 percent in 2009-10 to 2.8 percent in 2010-11, and the RBI had itself belatedly admitted that most of the persistently high consumer price inflation in the country was being caused by supply bottlenecks and a galloping rise in world commodity prices. Thus all that persisting with high interest rates could possibly do was to pull growth down further and trap India more tightly in a cycle of stagflation.
Therefore, everyone had expected the RBI to announce a lowering of interest rates. New Delhi’s numb acquiescence in the RBI’s action broke the confidence of investors all over the world in the Manmohan Singh government’s ability to manage the Indian economy. Between July and November 2011, the rupee lost 18 percent of its value. The change of investors’ perception was summed up by James Lamont of the Financial Times. “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 New Delhi’s painfully slow or inconsistent decision-making. Many local companies are focussing their investments on Africa or Latin America. India has quickly come to regret Manmohan Singh’s second term as prime minister.”
The second sharp slide, of 11.5 percent, took place in a similar manner during a 63-day period between 5 May and 8 July this year. These dates are not fortuitous. 5 May was the first working day after the RBI’s May policy review, in which it cut lending rates by a quarter of a measly percent and, for good measure, added that even this magnanimous concession would depend upon the future good behaviour of prices. Since India is suffering from cost push, and not demand pull, inflation, whose course does not depend upon domestic monetary or fiscal policy, investors concluded that their money would never be safe in India and began to take it out.
The slide halted, at least momentarily, on 8 July, because this was the first working day after the government signalled its determination to bring the fiscal deficit down further, by doubling the price of natural gas and raising the price of diesel. A sharp rise in the Sensex and Nifty in the next few days signalled the small return of confidence that followed.
Since last September, New Delhi has been convinced that interest rates have to go down. But by endlessly delaying the lowering of interest rates, the RBI has given birth to new threats that make their reduction fraught with new risks. Chief of these is that any rise in consumer expenditure and investment now will spill over into imports and further widen the current account balance of payments deficit. With India’s foreign debt now a third more than its foreign exchange reserves, this may make it very difficult to release foreign exchange in order to defend the exchange rate. Yet, not doing so and allowing the rupee to slide further will open scores of large companies, which have borrowed heavily abroad to take advantage of low interest rates, to the risk of defaulting on their debt abroad.
This risk has to be taken because India has run out of options. However, it may be considerably smaller than it looks to the RBI. Because a sharp cut in interest rates will immediately start to push up share prices. Coming on top of the deficit cutting measures the government has already taken, this could revive confidence in the economy within weeks and make Foreign Institutional Investors’ and Non- Resident Indians’ money start flowing back into the economy. That inflow will at least partly offset the short-term widening of the current account deficit and minimise the further fall of the rupee.
If the RBI does not have the courage to cut interest rates now by at least 2 percent all round, then the UPA government must force it to do so. It should not forget that it has an election to face, and the chances of winning it will be infinitely brighter if the economy is expanding and jobs are being created, than if it is not.