Monday, July 18, 2016



Rangarajan is innocent

Reserve Bank’s progressive tightening of monetary policy is drawing blood; many businesses are feeling the pinch, and economists are beginning to fear that Venugopal Reddy is aspiring to follow in the footsteps of his distinguished predecessor, Dr C Rangarajan. When faced with rising inflation in 1995, Rangarajan had clamped down on bank credit. Many companies that had ordered equipment could not get credit to buy it, many that had expanded capacity could not sell their goods because they could not give distributors credit, and many found their clients canceling orders because they did not have money. Businessmen are wondering if they are going to see a repetition of the bloodbath of 11 years ago.
In a speech to Bombay Chamber of Commerce on 9 April, Rangarajan defended his action. He said that the recession that following monetary tightening was due to the meltdown in East Asia – and implicitly declared himself innocent. His defence is wrong on timing. He began to tighten credit in late 1995; there was no sign of the East Asian crisis till 1997. The troubles of Indian borrowers started in 1996, on account of credit shortage, not lack of demand; the demand slowdown spreading out from East Asia did not strike Indian shores till 1998.
Reserve Bank’s handling of the East Asian crisis was also mistaken. It maintained the Dollar-Rupee exchange rate at a time when East Asian currencies had been devalued 30-70 per cent; thereby it gravely hurt Indian exports, and exposed Indian industry to lower prices of competing imports than it would have been if the Rupee had been devalued. Rangarajan very properly avoided this mistake, for it was not his; it was that of his successor, Bimal Jalan. They were responsible – though certainly not solely so – for the crisis of 1996 and the ensuing slow-down, which ended only in 2003. The average growth rate in those 7 years half of the 9 per cent that we have recently achieved. If we had not lost all that growth, we would have been 35 per cent richer today. Of course, it would be wrong to assume that the path would have been smooth but for the roadblocks introduced by Reserve Bank, or that other policy-makers would not have made other mistakes. So 35 per cent is the upper limit. But 20 per cent would be a reasonable estimate of the loss they caused.
The errors would no longer matter since Rangarajan and Jalan long ago left their governorships. But Rangarajan continues to be the Prime Minister’s most trusted economic adviser; the errors he now makes have the potential to be magnified manifold. This is why his spirited defence of the current tight monetary policy is important. According to him, rising inflation, widening deficit on current account and 21%-plus growth in money supply were indicators of an overheated economy. He thought it important not to turn what is now a cyclical problem into a structural one; to put it in simpler English, he meant that if inflation continues to be high, people will get used to high inflation, and we will have permanently high inflation – which would require perpetually high interest rates, depreciating exchange rate and periodic payments crises.

Certainly, if the choice were so put to them, most people would choose the yet unknown effects of monetary tightening in preference to the frightening prospect Rangarajan laid out. But his question was a rhetorical one; it already implied its own answer. People should ask another question: is tight monetary policy the only instrument available to the government against inflation? The answer is no; there is also fiscal policy, and it is superior under present circumstances. For one thing, tight monetary policy acts only against investment and inventories, whereas fiscal policy can work against all components of demand, including consumption. For another, monetary policy has the strongest impact on banks and their borrowers, which are mostly small businesses; taxation can impact the incentive of all investors – big companies, small businesses, and personal borrowers. There is something Rangarajan has missed out in his policy prescription; and he is too good an economist to have missed it out inadvertently.