THE INVESTMENT SLOWDOWN led growth deceleration in the Indian economy last year is the cause for angst in official circles now. A plethora of reasons are being offered by different agencies and different policy makers, to first explain the slowdown and then to shift the blame from their own organisations on to other official organs.
For instance, the Reserve Bank of India is going to great lengths to exonerate itself of blame for the drag in investment activity.
On the other hand, almost all corporate lobby groups have been steadfast in demanding lower interest rates from the RBI for the past two years. As for government is concerned they will prefer lower interest rates? Implicit in this view is that not much importance needs be placed on other ‘explanatory’ factors such as policy paralysis, loss of reform momentum etc. For, reforms as they have so far been carried out, are still in place and there have not been too many roll-backs. For instance, we did not have higher FDI in insurance or in retail. Infrastructure is broadly where it has been in the past decade and more. Government budgets were still in big deficit mode. But, there was still high growth. The key differentiator then is high interest rates.
If the central bank is not able to maintain the credibility of the paper currency, modern economies could well go back to an earlier era of metals (prominently gold) and even to the barter era. But,which modern economy wants to abandon the paper currency system and return to a gold standard now? The benefits of the fiat money are just too great to contemplate any such reversion.
Countering this line, the RBI has said that both nominal and real interest (lending) rates have secularly declined in the past 15 years. Moreover,real lending rates (nominal rates adjusted for inflation) now are some 50 per cent lower than their average level of 7 per cent in the economy’s investment boom period from 2003 to 2008, the RBI says. It further points out that a clear negative relationship between real output growth and real lending rates, which was in existence for much of the past 15 years, has weakened noticeably in the recent past. Clearly, factors other than interest rates also have a key role in determining investment activity. The RBI has gone on to identify those other factors as global uncertainties, structural constraints, loss of pro-reform policy momentum, inflation persistence and increasing business uncertainties.
Narrow RBI objective...
A perusal of these arguments shows that there is not much the RBI can do about global uncertainties, structural constraints and loss of pro-reform policy momentum.
The last two need not be understood only in some physical infrastructural sense or in terms of the ab-sence (or presence) of key policy makers. It has to be understood in a larger political-economics context where economic policies are subject to the preferences of the elected political party. The central bank has to keep making policies irrespective of whatever the structural environment actually is.
Given this framework, it is clear that the central bank has to work towards some narrow economic objective. Such an objective should be appropriate for whatever the under-lying structural environment is. In other words, the narrow economic objective can only be intermediate in nature and will be a key support to the larger objective of higher output growth – which would be the preference of different types of structural arrangements.
What can be such a narrow economic objective for the RBI?
Price stability, the main objective...
For any monetary authority, the basic and only objective can be guaranteeing the credibility and stability of the fiat money (the paper currency) it is responsible for. The very nomenclature of the central bank as monetary authority makes that axiomatic.
The credibility of the fiat money system is maintained only if the purchasing power of the fiat money remains stable. If the central bank is not able to attain that objective, modern economies could well go back to an earlier era of metals (prominently gold) always and even to the barter era, where paper money did not exist. But, which modern economy wants to abandon the paper currency sys-tem and return to a gold standard now? The benefits of the fiat money are just too great to contemplate any such reversion. However, to ensure that the credibility of the fiat system is maintained, countries have progressively moved towards granting their central banks formal autonomy and freedom from political interference and mandating price stability as their prime objective.
Price stability and investments
Maintaining the purchasing power of the fiat money does not mean an unchanging price level continuously for all time. But, that does mean protecting the purchasing power of the fiat money in such a broadly stable manner that it does not vitiate the overall economic environment.
So, how can instability in the purchasing power of fiat money vitiate the overall economic environment and in particular, the borrowing, investment and consumption decisions of firms and households?
Well, the RBI itself says in its latest Annual Report that inflation persistence is one of the factors behind the investment slowdown.
It must be understood that investment is a leap of faith by the entrepreneur that the value of money (inflation) will be broadly stable for the future period(s) into which he is investing. If today the government is complaining that investments in the economy are down and fluctuating, it is also on account of the uncertainty caused by high and unstable inflation – over and above all the other factors relating to tax policies, tariff policies,environment-related regulations and lack of pro-reform policy momentum etc.
Basically, instability in the aggregate price level muddies the waters by making it difficult for the firm to determine whether changes in individual prices reflect fundamental changes in supply and demand or changes in the overall rate of inflation itself. Investment decisions based on optimistic forecasts of real returns come unstuck when the firm finds that price level changes are not only at the relative level, but at the aggregate level also. The overall result is over or under-investment and pronounced swings in the investment cycle. If debt/equity is high in this environment, what will be the impact on the debt servicing ability of the firm? One should not be surprised, in this backdrop, to find the quality of financial sector loan portfolios under quite some stress in recent times.
Investment decisions based on optimistic forecasts of real returns come unstuck when a firm finds that price level changes are not only at the relative level, but at the aggregate level also. The result is over - or under-investment and pronounced swings in the investment cycle. If debt / equity is high in this environment, what will be the impact on the debt servicing ability of the firm?
RBI reforms, the imperative
It should be the paramount objective of the monetary authority to ensure that relative price level increases do not morph into aggregate price level increases. That is the most powerful tool the monetary authority has to promote sustained investment, long-run output growth, high employment and financial stability.
But, if the history of Indian inflation and corporate investment is any indication, India has not succeeded in ensuring such an outcome. The prices of all goods and services (GDP deflator) have had a CAGR of 10 per cent plus in the past 15 years. This is well exemplified by the RBI Governor’s recent statement that he pays Rs 150 now for a haircut compared to Rs50 a decade ago.
This implies that supply-side shocks have been monetarily well accommodated over the past decade and more. The admission about low real interest rates and the fears about suppressed inflation on account of un-revised oil product prices only testify to that. By no stretch of imagination can it be said that the RBI has been an inflation hawk, as is commonly believed.
Deep institutional reform of the RBI is called for if India is to avoid the trap of volatile investment and overall economic and financial instability. The RBI has to be given a narrow mandate on price stability and it must develop the policy tools and systems necessary to attain that objective. It is no longer fashionable to say that the RBI can be the jack of so many trades –monetary authority, exchange rate manager, debt manager, regulator and supervisor of banks, NBFCs and all financial intermediaries performing the basic borrowing / lending activity. That seems anachronistic in today’s complex economic environment. That is also a sure recipe for sub-optimal overall performance as is being proved by the inflation stubbornness, disorderly domestic foreign exchange markets, heightened uncertainty in the investment environment and significant strains on financial sector asset quality.