RBI: Time for Introspection 

 
ARVIND PANAGARIYA 

PROFESSOR,COLUMBIA UNIVERSITY 
Till the central bank manages its dollar war chest effectively,its focus on inflation will not yield results

India has now had a full year of growth below 6%.During the year ended June 30,2012,India grew 5.9%.During the second half of this year,growth was even lower at 5.4%.Compare this growth with the average growth of 8.25% during the immediately preceding year ended June 30,2011 a solid 2.35 percentage points have,thus,been shaved off the annual growth rate.The decline is even sharper if we compare this growth to the last quarterly peak of 9.2% during the first three months of 2011.A part of this slowdown is to be attributed to the paralysis in decision-making from which the government is recovering only slowly.The role of the paralysis is corroborated by the disproportionate slowdown in mining and quarrying and manufacturing,which are more susceptible to government decision-making.Services,which are less dependent on the government,have been impacted less.Mining and quarrying saw negative growth of 0.95% while manufacturing grew a marginal 0.85% during the year ended June 30,2012.This being said,perhaps the greatest across-the-board negative impact on growth has originated in the severe monetary brakes that the Reserve Bank of India (RBI) has applied.The story of the 13 consecutive interest rate hikes beginning in March 2010 and ending in October 2011 is well known.Less well known is the severe restraint the RBI has applied to monetary growth.Adequate monetary growth provides the grease that oils the forward movement of a growing economy.While too much of it can make the aggregate demand run ahead of real incomes and,thus,fuel inflation,too little of it can arrest,even cripple,the forward movement.Over the decades,the RBI has maintained a relatively steady double-digit annual growth in the monetary base,which determines the availability of credit in the economy.It averaged 17% during 1982-96 and 14% during 1996-2008.But during the last year,2011-12,the central bank suddenly squeezed the growth in monetary base down to barely 3.7%.The slowdown has continued in the fiscal year 2012-13.On the last Friday in September 2012,the last day for which data can be readily accessed,monetary base stood at only 4.4% above its level a year earlier.These growth rates compare with monetary expansion of 17% in 2009-10 and 19% in 2010-11.This credit squeeze,complemented by high fiscal deficits,has administered a double whammy on the private sector.Traditionally,the RBI has set growth with macroeconomic stability as the objective of its policy.Lately,it has abandoned the growth objective altogether.And even with respect to macroeconomic stability,it has chosen to focus nearly obsessively on just one,even if key,element in such stability: inflation.Setting aside the exceptional years of 1996-97 to 2007-08,inflation rates in India have never been in the 5% rage on a long-term basis.Yet,the RBI has decided that any inflation in excess of 5% is to be combated at all costs.

Ironically,the RBI has had at best partial success even in combating inflation due to its poor management in another key area: the external sector.After India adopted the flexible exchange rates in the early 1990s,the long-standing practice of the RBI had been to intervene in the foreign-exchange market to smoothen out short-run fluctuations while leaning against excessive appreciation of the rupee in the longer term.That policy stance provided short-run exchange-rate stability while allowing the RBI to build up substantial foreign-exchange reserves over the years.But some time around 2009,perhaps responding to the US criticisms of the Chinese interventionism,the RBI decided to be a good boy and adopted a hands-off policy in the foreign-exchange market.When the rupee began appreciating even in nominal terms in 2009-10,it chose not to buy dollars to soften the rise,thus forgoing the opportunity to beef up its dollar war chest that would aid in combating future depreciation of the rupee.Simultaneously,the RBI progressively eased the restrictions on external commercial borrowing to buy off the corporate lobbies.While small and medium firms struggled to borrow at extra high domestic interest rates,liberalised external commercial borrowing gave corporations access to low interest rates abroad.But these policies have not been without consequences for the RBI and the economy.The gross external debt rapidly climbed from $224 billion at the end of 2008-09 to $346 billion at the end of 2011-12.This debt significantly exceeded the foreign exchange reserves of $294 billion at the same time.Rising external debt and the failure to accumulate dollars in good times have left the RBI vulnerable on the external front.In consequence,the ability of the RBI to credibly intervene in the foreign exchange market to stem rupee depreciation this past year was greatly compromised.So,the rupee went into free fall with obvious consequences for inflation.A depreciating rupee meant rising rupee prices of oil and other imports even if the world prices of those goods did not rise.A fiscally-strapped government had no choice but to pass on a large chunk of this price rise to the consumer.And that left the RBI with only one option if it were going to insist on keep clamping down on inflation : yet greater squeeze on monetary base.

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AFTERTHOUGHT 

A bank is a place that will lend you money if you can prove that you dont need it. 

Bob Hope,English-born American comedian