Central confusion

While the RBI criticises policy, it does not use its own limited authority effectively.

Written by Arun Kumar | Published:July 23, 2015 12:42 am
RBI, Raghuram Rajan, RBI governor, Indian economy, interest rates, inflation rate, Monetary Policy Framework, RBI, wholesale price index, WPI, consumer price index RBI Governor Raghuram Rajan.

The RBI governor has been criticised by officials of the finance ministry for speaking on the economy in less than positive terms last month. Was it wrong for him to do so? The ministry would like to create positive sentiment in the economy, especially at a time when a drought is forecast. The governor has been making his differences with the government clear by not bowing to the finance minister’s pressure to sharply lower interest rates. The result is confusion in the markets.

In India, the central bank’s autonomy is limited, but the issue is whether it is being effectively used. The RBI has been arguing that its primary task is not to spur growth but to control the rate of inflation. A Monetary Policy Framework Agreement has been concluded, which binds the RBI to keeping inflation below 6 per cent. With a reportedly looming drought, this is going to be tough. But how will inflation be measured? Using the wholesale price index (WPI) or the consumer price index (CPI)?

Neither the WPI nor the CPI truly represents inflation in India. The services sector’s share in the economy is now more than 60 per cent and it is not represented in the WPI. It has only a small representation in the CPI. Thus, if school fees or health costs go up, or insurance charges rise, none of these will be captured in the official inflation figures. In effect, the RBI is not really targeting inflation. Why has the RBI not used its autonomy to create improved inflation indices that can help it meet policy targets better?

Similarly, there has been a controversy about the current rate of economic growth. The RBI needs this data to justify its stance on cutting interest rates slowly. If the rate of growth is already healthy, why the tearing hurry to lower interest rates when inflationary expectations are not yet tamed? International oil prices are fluctuating and have not stabilised. A bad monsoon, coupled with a rise in energy prices, could result in a rapid rise in the rate of inflation. Events in Greece are unlikely to result in stability any time soon.

It is widely suspected that the rate of growth is not what the government’s statistical agency suggests. The index of industrial production (IIP) data, slow growth in the core sector, slow rise in bank credit, decline in exports of late and slowdown in services and agriculture are all indicators of a sputtering rather than a roaring economy. The RBI could give alternative, credible estimates.

The government claims that the upward revision in growth is due to the new method of calculation — especially with respect to the contribution of the industrial sector. First, this sector’s coverage has been made more extensive; and second, the calculation is based not on the value of production but the value added in production. But neither of these would automatically lead to a faster rate of growth for this sector or for the economy.

Smaller companies that weren’t covered earlier are not necessarily growing faster. So why would a larger coverage lead to a higher rate of growth? Further, value addition is made up of profits and wages. Neither is rising rapidly. That is why the government’s collection of direct taxes has been less than what was targeted. The rising non-performing assets of banks also suggests that industry is struggling.

But there is an even bigger lacuna in the growth data. India has a big black economy. Thus, a lot of value addition is not counted. The actual rate of economic growth is the average of the black and the white rates of growth. The implication is that the official rate of economic growth has a big error in it. Why has the RBI not worked on this and corrected the rate of growth to get more robust policy prescriptions? The black economy requires for its circulation additional liquidity and, therefore, it affects money supply and the money multiplier — crucial inputs in the equations used by the RBI to determine policy.

In brief, the limited autonomy that the RBI has could have been used to settle some of the critical issues, such as the black economy, money supply, true rate of inflation and growth. The public would have been more supportive if the RBI had sorted these out. But this has not happened and this dents the central bank’s credibility. It also confuses the public since the RBI is part of the establishment and yet, is critical of policy. Is the RBI putting the cart before the horse?

Kumar, Sukhamoy Chakravarty Chair Professor, JNU, Delhi, is author of ‘Indian Economy since Independence: Persisting Colonial Disruption’.

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