The author is former director general, National Council for Applied Economic Research [email protected]
The management of the monetary system in the last decade has resulted in some apparent successes. Inflation has been at low levels for longer than we have known for decades. Interest rates have come down very sharply, and there is considerable surplus liquidity in the banking system. Foreign exchange reserves have risen to levels we did not dream they ever could, and they are continuing to rise. The rupee, despite being more influenced by the market than in the past, has declined very slowly.
But the low levels of inflation have been accompanied by lower rates of gross domestic product growth than in the first half of the Nineties and lower than in much of the Eighties. The composition of the gross domestic product growth has also changed dramatically. Most of the growth has come in the service sector, not in manufacturing or in agriculture. Indeed overall industrial growth has been distressingly low, and manufacturing within that has fared worse. Export growth has also decelerated, with a pick up only in the last few months.
The balance of payments deficit on current account has never been as low as it is today. It has been accompanied by a sharp fall in imports for manufacturing purposes. Improvement in exports has been in information technology and other services like entertainment and of foodgrains, jewellery and diamonds, and not in manufactures. Petroleum and related products have risen in import value more because of the rise in their prices than to galloping consumption. Prices may rise further with the Iraq imbroglio.
There is a demand recession that has badly affected fast-moving consumer goods and many industrial products like steel, but consumer durables and house construction have shown steady but erratic growth. Their growth appears to have been driven by lower prices, special promotions and above all by the availability of cheap credit. Deferred payments for consumption of such products have boomed. Most banks have started special drives to get this business and have tie-ups with many manufacturers of cars, two-wheelers, white goods, entertainment electronics, real-estate developers and the like. It is these that have been most helped by the falling interest rates, not capital goods or intermediates. Overall industrial growth has been a fraction of that in the first half of the Nineties.
The other segment of the economy that has benefited by lower interest rates is government, the largest borrower in the economy. It has seen a sharp decline in interest costs on its borrowings. Government borrowings have reached levels where both the Centre and the states are borrowing to pay interest and are squeezed for funds for their developmental functions. But despite lower interest rates, capital formation in the economy has not seen significant growth for almost six years. Primary equity markets have been very dull and almost all the limited equity that has been raised has been by means of private placements.
Financial institutions (Industrial Development Bank of India and Industrial Finance Corporation of India), that in the past were the major financiers of equity and debt for new investments do not have much liquid funds, with excessive amounts locked up in non-performing assets, and such funds as they have raised at higher cost than borrowers are willing to pay. The farsighted ones like ICICI have converted themselves into banks with consequent reduction in non-performing assets to total loans now measured against other norms, and with increasing focus on consumption loans. Lenders are reluctant to lend to industry because of high-risk perceptions. In any case, low levels of new issues of primary equity make it difficult for many enterprises to present acceptable cases for lending. Public investment has also been depressed for some time, with almost negative growth in recent years.
The relative steadiness of the foreign exchange value of the rupee is a compliment to the Reserve Bank of India’s management. In a time of relative industrial stagnation, it was perhaps necessary not to discourage imports by a sharply declining rupee. But the relatively steady rupee helped keep the value of imports, more than half of which is made up of petroleum and gas, to relatively lower rupee levels, keeping down the liability of government and government-owned oil and gas companies. Thus the main beneficiaries of lower interest rates and a relatively steady rupee were government and other borrowers for consumption, not investment.
The RBI’s monetary management has somewhat eased the government’s task of fiscal management. It has helped Central and state governments to postpone actions for bringing down expenditures since deficits have been made to seem steady.
An achievement of the last five years has been the huge accretion to foreign exchange reserves. These are almost entirely in free foreign exchange, not in gold nor increased debt. Short-term debt has fallen in the overall foreign debt. The cause has been the improvement in the current account deficit in the balance of payments, itself a result to a large extent, of the relatively lacklustre performance of the economy, leading to less demand for foreign goods. Reserves protect imports, ensure timely debt-servicing and for a while can help to curb speculation. But accretion (and low inflation) can continue if the overall economy improves, especially in manufacturing, and second, through the use being made of these rising reserves to benefit the economy.
As the economy improves, we can expect imports to rise, especially of the largest component in India’s imports, petroleum and related products. In the last three years, these have not grown at the earlier rates. In processed petroleum products, we became a net exporter after Reliance Petroleum went on stream. Capital goods and intermediates imports will also revive with the economy. As the world economy improves, so should India’s earnings from exports of information technology, agricultural and manufactured products and other services, while diamonds and gems and jewellery will get a further boost.
But the chances are that we will revert to current account deficits at 2 per cent of GDP or higher that planners estimate to be the safe number for sustainable imports and debt-servicing. Of course the revival of the economy may also lead to greater foreign direct investment and foreign institutional investment inflows of capital. One can say that while the reserves may grow, their rate of growth will fall sharply.
Are the reserves earning an adequate return' Given the very low interest rates in the developed economies, the scope for earnings in excess of administrative costs may be small. Modest changes, like allowing overseas expenditures by exporters, investors and some consumers, have not helped to stimulate the economy. Traditionally, reserves are not intended for stimulation but to safeguard payments for normal transactions and to serve as protection against speculation. But at least some part of the reserves could have been used to stimulate the domestic economy. This can still be done.
In summary, the RBI has had a very successful period of monetary management (low inflation, steady rupee, large forex reserves, lower interest rates). But while these have helped government deficits not to rise as much as in the past, it has not improved economic growth. In fact, low interest rates might be detrimental to savings in the immediate future, though in the long term, savings might rise as people adjust to lower earnings from savings. Consumption has increased on the back of low interest ra- tes and substantial additional liquid-ity, but investment has not increased.
World recession has helped to improve India’s balance of payments deficit on current account. Foreign exchange reserves have shot up as a result. This may continue, but at a slower rate with economic revival. Monetary management by the RBI has worked, due in some measure to adverse economic circumstances. The government has to integrate it into a plan for better economic growth and better control on its consumption expenditures and improved revenues.