Economic Highlights

New Delhi, 31 July 2008

RBI’s Squeeze Therapy

LEAVES ECONOMY GASPING FOR BREATH

By Shivaji Sarkar

It is a classic case of a failed diagnosis but the doctor continues with his prescription. This is how the Reserve Bank of India’s (RBI) yet another increase in the repo rate by 0.5 per cent and credit reserve ratio (CRR) by 0.25 per cent needs to be seen. For almost one year, the RBI has been continuing with this prescription for containing inflation, which continues to gallop.

The prescription of the RBI Governor Dr YV Reddy, has not only failed, in the RBI’s own assessment it has also started smothering the patient --- the industry, manufacturing sector and the overall growth momentum.

The increase in the CRR and repo rate has made financing dearer, almost at usurious level, but there is little sign that it would lead to a fall in prices. The RBI had taken the steps with a view to bringing down the broad money supply, called M3 in economic parlance. It was placed at 20.5 per cent on 4 July as compared to 21.8 per cent a year ago, when inflationary pressure was at a moderate level. It means that the RBI’s age-old belief --- squeeze the money out and prices would moderate --- is a faulted mechanism.

On the other hand, it has made the entire economic system gasp for breath. The credit squeeze is playing havoc with home loan borrowers, who had borrowed almost a decade or even 5 years back. The RBI has not been able to come up with a rationale for punishing the borrowers. The money was available cheap to the banks and that is why they had given the credit at a lower interest rate.

There is little rationale for increasing the rates on loans older than five years. It, of course, helps the modern “mahajan” (as the private money lenders are called) that the nationalized and commercial banks increase the interest rates.  While higher interest rates fatten the coffers of the banks it leads the borrowers to penury. At least of old lendings. As recent reports suggest, in the case of new loans, repayments have also suffered. (The ICICI and some other banks have reported this trend.)

Are we heading for a sub-prime crisis of the US type?  If the repayments suffer, primarily because of higher interest rates and consequent higher monthly installments (EMI), the RBI may succeed in further bringing down the M3, but it would certainly play havoc with not only the banking system but the entire economy. It would cause a drought of money. The lenders money would not come back to him.

Importantly, Dr Reddy’s squeeze therapy would certainly squeeze them out! It is like throwing the baby with the bathtub. Needless to say, Reddy needs to change the prescription. True, he had started taking measures a year ago to stop speculative activities in the housing sector, which was thriving on easy credit. But Reddy’s prescription had little impact on the speculative activities, because it was not backed by any Government regulation.

Sadly, if anyone has been hit, it is the poor and middle class borrowers. Clearly, Reddy needs to have a re-look and revise his prescription. The lending rates need to be lowered and those who have borrowed more than five years ago need to be given relief at the rate of that time. This would give some acceleration to the economy.

His prescription has also had an adverse impact on all economic players. As accepted by the RBI the growth in 2007-08 has not only been lower than 2006-07 but is likely to further decelerate in the current fiscal year. The process of moderation had started in the second half of 2007. Coincidentally, that was the time when the RBI had ushered in a regime of making credit dearer.

According to Reddy, industrial production further halved to 5% in April-May 2008 as against 10.9% in April-May 2007. The industrial deceleration was driven by both the manufacturing and electricity sectors. The manufacturing growth came down to 5.3% from 11.8% last year. The electricity sector too witnessed a sharp slowdown --- at 1.8%--- the lowest growth since 1994-95, when Manmohan Singh was India’s Finance Minister.

The consumer goods sector also recorded deceleration. This indicates a grim scenario. It suggests that the buyers have been so drained out that they are left with little surplus. The decline in the household saving rate further supports this premise. This has resulted in a fall in corporate sales to 18.5% in 2007-08 from 26.2% in 2006-07. Corporate profits have also plunged to 14.1% in 2007-08 from 39.6% the previous year.

More. The growth in the core sector has halved to 3.5% compared to 6.9% in April-May last year. Two major reasons attributed for this are failures in the electricity sector and subdued performance of the petroleum refinery products sector. The hydro, thermal and nuclear energy sectors also performed poorly. The petroleum sector declined sharply on account of high international prices and led to a decline in production in some of the public sector refineries.

Not only that.The financing, insurance, real estate, construction and business services sectors also recorded severe deceleration. The decline in cargo handling at ports indicates a further slowdown in economic activities. Civil aviation, steel and cement also recorded an overall fall in performance owing to a fall in activities in the construction sector.

Worse, the National Council of Applied Economic Research (NCAER) quarterly business expectation survey, the Confederation of Indian Industry (CII) business confidence index and the RBI’ industrial outlook survey all indicate negative trends for the next two quarters of the current year.

The indications are clear. Governor Reddy’s prescription has not worked and is not expected to work. He has borrowed the concept from the West. He needs to dump it. Expensive finance is squeezing every one out of business. As the custodian of the Indian economy, he needs to post haste thoroughly review the RBI’s policy, not after the scheduled three months in October.

In sum, a revitalization of the credit policy, with lower and easier financing norms is necessary. It has made every necessity dearer putting the entire economy out of reach of everybody.

If the RBI fails to do so, the nation would be back to what was known and despised --- the Hindu rate of growth --- coupled with high inflation. There is no gainsaying, that recent developments clearly indicate the nation is heading towards such a scenario unless there is a drastic change in outlook and mindset.----  INFA 

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