Monetary policy now rests on a wing and a prayer

The latest monetary policy announcement made on December 4 held no surprises. It held the status quo on the key interest rates — the repo and the reverse repo — that act as the floor level for interest rates in the wider economy. Instead, the focus on the latest announcement — the last before the next Union Budget — was on spinning a positive narrative for growth. But just how credible is such speculation?

The supposedly pro-growth “accommodative” monetary policy stance rests on making liquidity available in the system. Justifying this accommodation was the Reserve Bank of India’s latest estimates of GDP growth in 2020-21. The RBI now expects GDP to contract by only 7.5% in the current fiscal year, not by as much as 9.5% it expected earlier. Significantly, it expects positive growth for the first time in the second half of the current financial year — by a tepid 0.1% in the current quarter, followed by 0.7% in the last quarter of 2020-21. Further, it expects at least 6.5% growth in the first half of 2021-22.

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Inflation mars an otherwise rosy scenario

The only thing that mars this otherwise rosy report card is the scenario for inflation. Ostensibly, this is what has ruled out any possibility of a further rate cut any time in the foreseeable future. Inflation, which is currently within touching distance of 8% — and which has already breached the RBI’s mandated target of 4-6% — is obviously the reason why it has pushed the pause button on rate cuts in a desperate means to coaxing investments.

It is true that the opening of the liquidity tap soon after the lockdown prevented the immediate collapse of companies. But the Finance Ministry’s expectation that liquidity would fill in for the actual flow of credit to companies, especially smaller entities, through commercial banks, was obviously hoping for the impossible. Commercial banks, especially those in the public sector, were obviously unwilling to lend because of their poor balance sheets. Beleaguered banks, laden with non performing assets, could hardly have been expected to embark on fresh lending. Now, rising inflation has put paid to any further rate cuts, leaving the primary monetary policy lever practically ineffective.

Moreover, the difference in interest rates that lenders are able to charge on the loans they advance and what savers are able to get (for instance, on bank deposits) has widened to a point that is clearly indefensible. Speaking at a discussion of the economy organised by Ahmedabad University on December 5, former Chief Statistician of India Dr. Pronab Sen pointed out a serious anomaly in the interest rate regime. He pointed out that while lower base rates have enabled lenders to access funds at far lower costs, thereby retaining their margins, depositors were effectively reduced to losing money on their investments because of the sharp fall in rates of interest on deposits. The widening spreads in returns between these two classes of economic agents has serious consequences, including ethical ones, he remarked. Happening as it is in a situation where there has been net dissavings in the Indian economy since the pandemic, it points to a limit on investments in the future, observed Dr. Sen.

RBI’s cheery prognosis

The rest of the Monetary Policy Committee’s cheery prognosis for the Indian economy rests on speculation based on insufficient information about the state of the economy. Its assessment that a recovery of the Indian economy is underway is based on what it terms “high frequency indicators” — that is, data about specific segments of economic activity that comes in more quickly than more measured (and reliable estimates) but which come with a significant lag. It is important to reiterate that the RBI does not have the apparatus to make comprehensive independent estimates of GDP as does the National Statistical Organisation.

What is the basis for this cheery optimism, which the Finance Minister, those at the Niti Aayog, the RBI and, of course, the captains of industry seem to share wholeheartedly? While the booming stock market appears to reflect and justify their optimism, a healthy dose of scepticism may well be in order. Otherwise, we may well be led astray by the voices emanating from an echo chamber.

Although it is true that several indicators such as vehicle sales — especially of cars and two-wheelers — seemed to have picked up, especially during the Diwali festive season, two important caveats are in order. First, the long period of lockdown and the sputtering reopening of the economy thereafter, has meant a sudden release of pent up demand. Second, this release coincided with the festive season, the peak demand season generally in India for many goods, especially consumer durables and nondurables (like clothing and footwear). Thus, much more evidence is needed to confirm that the recent uptick will extend into the future as well.

Collapse of private investment

The GDP data for the first two quarters reveal that during the first quarter private consumption was higher than investment, implying a significant drawdown of savings to feed consumption during the pandemic. Dr. Sen pointed out that although this had been reversed during the second quarter, it was not enough to make up for the earlier collapse. The dissaving by economic agents is thus likely to affect investment well into the future. “The multiplier process (which results from investments leading to further impetus to economic activity) has suffered a setback,” observed Dr. Sen.

Although it is tempting to see the sustained rally in the stock markets as a hopeful sign, several features of the current upsurge make it stand apart from previous bull runs. Most significantly, unlike in most rallies of the past, when companies would queue to raise funds from IPOs, not a single significant IPO has taken place during the current boom. After all, IPOs are the cheapest source of funds for companies. If that is not happening, it only points to the risk aversion among potential investors, observed Dr. Sen. Moreover, there is no “corroborative evidence” — for example, of increased term lending by banks — to indicate investor appetite, he added.

Although there is some anecdotal evidence that construction activity is picking up again — especially in rural and semi-rural areas — it is not clear whether these projects are new ones or are simply those that were already in the pipeline before the pandemic. Dr. Sen is skeptical whether “new investments” are going to flow in. “There is a big fear that the pipeline may get empty soon,” he observed. Dr. Sen also noted that since the construction industry in India is largely driven by public investment — in projects and schemes, for instance — the slowdown of public investment by both fiscally stressed state governments as well as by the Centre may have a dampening effect on future growth.

States under stress

But Dr. Sen’s biggest worry is about the ability of states to not just initiate and participate in an economic recovery, but about their ability to keep the fight against Covid-19 alive in the months and days ahead.

Pointing out that the states “have been spending far more (than the Centre) in fighting the pandemic,” he fears that they “will be running out of money by the fourth quarter,” which may force them to reduce expenditure.” With Covid still not showing signs of “going away,” and if states run out of money, “the fight on the disease management front is going to be a huge challenge.” “In that situation even simple things like testing (Covid-19) may get seriously curtailed,” he warns.

The irony of the situation is that the states would cut back expenditure precisely at a time when they need to spend, in order to compensate for the collapse of overall consumption in the wider economy. “If anything, the Centre will need to spend more to compensate for both these curtailments,” he said.

Public investment needs focus, predictability

Dr. Sen warns that public investment needs to made with some “strategic thinking”. Since public investment was only one-fourth of overall investment even before the pandemic, and since private investment has collapsed since then, public investment needs to measured, coordinated and predictable. Only this will ensure that private investment will stay interested enough to make investments in the current situation characterised by uncertainty. Dr. Sen pointed out that “large sections of the private sector see the crisis as an opportunity.” “Some have lost competitiveness and others are taking advantage by pushing out competitors,” he observed. “There is a lot of predatory behaviour within the private sector,” he remarked.

In this situation, public investment needs to be targeted and may well have to be assured at least in the next fiscal year so that private investors are confident enough to take risks. Dr. Sen says the government needs to quickly decide about what its fiscal strategy is going to be in the next financial year. Only this will assure nervous private investors of sustained government investments over a longer time horizon. In order to do this, the government needs to assure investors soon about loosening the limits set by the Fiscal Responsibility and Budget Management (FRBM) Act during the next financial year, Dr. Sen opined. This would have a stabilising influence on investor sentiment at a time of great uncertainty, he added.

So far, the Indian response to the pandemic-induced shock has been led by monetary policy — tinkering with liquidity and interest rates — and hoping that funds will flow to economic units from the banks. This has not materialised. “Monetary policy cannot substitute for fiscal policy, but is ineffective when investors are unwilling to invest,” remarked Dr. Sen.