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Bold monetary policy key to turning the Indian economy around

Meghnad Desai
This is because fiscal policy has dominated over monetary policy, as the finance ministry has over RBI.

There is no doubt that we are in the downward phase of a growth cycle. Many critics of the government say that income is declining. It is not; it is growing, but more slowly than before. Cycles normally reverse themselves. The economy hits the bottom, and then starts rising again. Indian economy has not witnessed a cycle before, let alone a growth cycle. Can we be sure that the cycle will reverse itself, and not just continue its downward spiral?

The current growth cycle has been driven by credit, and as I wrote a while ago, is the first capitalist business cycle for India. In such cycles, the downturn is always marked by the insolvency of lenders, bank and nonbank, as well as of borrowers whose projects fail to make profits. When this happens, the way out is not the Keynesian one that increases consumer expenditure. Fiscal policy is not the appropriate instrument; it is monetary policy that is crucial.

Monetary policy in India has been quite timid, and limited. It has price stability as its declared task. Apart from its regulatory duties, RBI seldom takes bold action of the kind the Fed, or the Bank of England has taken in recent years. Given that the malaise is in the banking and non-banking credit markets, it should be the priority of the monetary authorities to fix the availability of credit, as well as to lower the cost of credit.

It is crucial also to reverse the pessimism of the markets. To do this, bold unorthodox policy is needed. RBI should conclude that the recent burst of inflation is a seasonal agricultural phenomenon. It does not require raising interest rates. The policy should be drastic cuts in interest rates, and injecting liquidity on the supply side. If this requires a form of Quantitative Easing suitably tailored to Indian markets, so be it. This is the first time India is experiencing a Wicksell-Hayek cycle, and the response has to be bold.

Thus, the non-banking credit market will have to be supplied with plenty of liquidity at non-punitive rates. The banking sector can be supplied by open market operations of the usual sort. But, it has to be massive. The source of the trouble is the collapse of credit, and this requires sorting out. What the government is good at is compensating farmers, and other distressed groups. But, they are the usual, and frequent, claimants. The need of business investment is paramount, and as profitability has collapsed, the restoration of investment remains key.

This is a challenging proposition for Indian policymakers. This is because fiscal policy has dominated over monetary policy, as the finance ministry has over RBI. But, now, the Indian economy has matured beyond the days when the government policy had to move the economy directly. Now, the initiative of growing should be with the private sector, and the government can behave as an agent, using the price mechanism rather than direct transfer.

This will not be easy for the government. It does not trust the market mechanism. The government has always treated the public, especially anyone engaged in profit-making activity, with suspicion and mistrust. Forms have to be filled, permits taken, and tax terrorism expected. Time has come to reverse this behaviour into one which helps businesses do what they normally should-invest, employ workers, produce, sell, and make profits while satisfying consumer needs.

The contempt that the political class shows for business (though happy to receive its clandestine donations) is reciprocated by the latter's contempt for official rules and regulations. Jugaad is, after all, cheating, cutting corners, and offering bribes to get things done rather than playing straight. The collapse of the non-banking credit market is a perfect example of jugaad, and its devastating effects. The NPA crisis in the banking sector is another example.

Debtors have used every means of delaying settlement. The judicial system aids and abets delaying settlement of any and every case. Lawyers are happy to be complicit because the law's delays mean more money for them. Inefficiency is rewarded.

There is a lot of cleaning up to do, not just on our streets, but in our attitudes towards business, be they in offices, factories, or companies. Growth is not automatic, nor can it be conjured up by public spending.

The writer is Prominent economist & Labour peer. Views are personal