January 2 saw some welcome moves by Indian policy-makers to bolster a weakening economy. After speculation in the previous few days that the Reserve Bank of India would act slowly or timidly, it ended up cutting its lending rate (the repo rate) by 1 percentage point to 5.5 percent, and the cash reserve ratio from 5.5 percent to 5 percent (effective January 17th). It looks like another 0.5 percentage point cut in the repo rate will come on January 27th.
Rates are down substantially from their late summer peaks, when the RBI was still tightening. I think the RBI tightened for too long, because it uses a backward-looking measure of inflation, and it is loosening too slowly as well. It is difficult to fully assess the impact or extent of the current loosening, since the CRR is being changed along with interest rates. Still, with all the signs that the real economy has slowed dramatically, and is growing well below its potential, it seems to me that the RBI could have acted more boldly than it has. Surjit Bhalla argues that the RBI simply reacts to lagged money supply growth in setting its policy interest rate, but this may be coincidental, unless a lot of what the RBI leadership has said and written in the past was just blowing smoke. It would be great if the RBI were clearer and more transparent about exactly how it makes its decisions, though.
Another round of fiscal stimulus was announced on the same day as the latest RBI moves. Clearly, the Finance Ministry and RBI are coordinating their moves. Central bank independence, which has never quite been the case in India, may rightly be shunted aside at a time like this. My question is still whether the right mix of fiscal and monetary policy isn’t a looser monetary policy and less fiscal loosening. In the US, fiscal stimulus is the main option when the Fed’s policy rate is close to zero the RBI has plenty of room to maneuver. Inflation receded as a threat quite some months ago, which was clear from more current measures of inflation than the year-on-year change that is normally what is the center of attention. In any case, the latest fiscal stimulus is not really a standard boost in expenditure. It eases overseas borrowing and adds some new tax breaks. Apparently, the latest stimulus has US $8 billion of forgone tax revenue, after an earlier boost of US $6 billion, which was more weighted toward increased expenditure. The net result is a hefty increase in the fiscal deficit.
There seem to be varied views on what will happen from here on. Montek Ahluwalia and others are gloomy, especially looking at the increasing problems of the global economy. Ahluwalia states explicitly that further monetary and fiscal stimulus will be needed. My own take is that monetary easing may be enough. The fiscal stimulus already announced should be enough, combined with the fiscal laxness that was already in place. If the US succeeds in boosting demand through its own fiscal stimulus, that may also reduce the need for India to do the same. In fact, Mahesh Vyas of CMIE is somewhat more optimistic. He has two recent articles analyzing the state and prospects of the Indian economy. In one, he argues that the Indian economy is fundamentally strong, that companies are investing, and that domestic demand is robust. He isn’t too worried about the fiscal situation either. In another piece, he focuses particularly on the index of industrial production and suggests that its decline is a short-term blip explained by the temporary credit crunch. The truth is probably somewhere in between. I think Vyas is a bit too rosy in his outlook, but I think the worst may be over for India. Predictions for growth 2009-10 are tending to be below 6 percent now, but next year may turn out about the same as 2008-09, with the second half seeing a pick-up. Essentially, this will be a U-shaped downturn for India, with the bottom spanning the second half of this fiscal year and the first half of the next. Mind that the second half of 2009-10 takes one into the first three months of 2010, by which time the US will also be turning the corner.
I sound like a broken record, but this is a great time for the government to push for financial sector reform, education reform and anything else that can relax bottlenecks in the supply of key factors in India’s growth. A crisis is a perfect time to push for reform, so if anything, it would be better to try for such measures rather than simply further fiscal stimulus. I think the current government has nothing to lose by being bold. It may as well take measures that will push the medium-term potential growth rate closer to 10 percent (it’s about 8 percent now), so that the recovery will not stoke inflation when it happens. India has the luxury of growing by simply removing inefficiencies.