How to be ordinary

Today RBI will address the short term problem. Question for long term: How to design monetary policy to stabilise the economy?

Recent data from the US and world markets suggests that 2008 may see a slowdown in the US and global economy. This is the biggest risk that India faces today. In preceding decades, the biggest risk to the Indian economy was a bad monsoon. Agriculture is just 18 per cent of GDP, and less than half of it is rain-fed. The world provides a much larger share of demand for goods and services than it ever did in the past; India is more linked to the world economy than ever before. If the world is going to face a slowdown, so will we.

Can government policy do something to reduce this impending slowdown of GDP? This is a novel question in Indian economic policy thinking. So far, public policy has been used as a way to give out benefits to favoured groups, often with detailed government interventions in certain sectors. Wheat farmers were unhappy so wheat futures were banned; exporters were unhappy so the rupee market was manipulated; an education cess was introduced to please an unknown constituency. Such pedestrian thinking was perhaps okay in a world where India did not have a business cycle.

This situation has changed. Like any other market economy, the

Indian economy has been witnessing business cycles since the 1990s. The breakdown of the dominance of the public sector manufacturing, the reduced importance of investment controlled by five year plans, the dismantling of industrial licensing: all these changes now imply that India experiences an investment-inventory cycle that is found in all ordinary market-based economies, but one that is very novel in India.

The essential feature that induces business cycles is this: investment, production and hiring decisions must be made based on expectations of market conditions. For example, the Chinese economy, where investment decisions by PSUs are based on extraneous considerations, lacks the business cycles seen in India.

In this new environment what can a government do? In developed market economies, fiscal policy and monetary policy are designed to combat the business cycle. Fiscal policy in market economies is not only about favouring this or that sector; it is also about stabilising the business cycle. Monetary policy in market economies is a precious tool that is not wasted on manipulating the exchange rate: it is devoted to stabilising the business cycle.

Most observers in India are euphoric about high GDP growth and seem to assume that above-eight per cent growth will persist for ever. This thinking fails to take into account the business cycle. We have swung between four per cent growth and nine per cent growth across a few years. Such an unstable environment puts fear into the minds of entrepreneurs and deters long-term investment.

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To prevent the pain of nationwide high unemployment, it is important to prevent recessions. To prevent recessions, it is important to prevent over-investment. If today there is excess investment, tomorrow there will be cutbacks. The job of fiscal and monetary policy is to stabilise the economy by reducing the volatility of GDP.

At present, monetary policy in

India is clearly not a force that enhances stability. In 1998, the RBI raised interest rates by 200 basis points when the Asian crises broke out and there were fears of a recession. This was the opposite of what one would have expected a central bank that stabilised GDP might have done. Similarly, after 2004, when GDP growth was accelerating and inflation was gathering momentum, the real interest rate was going down 8212; this was the opposite of what a stabilising monetary policy would have done. There is a lot of discussion about the RBI and stability; but the reality is that in India today, monetary policy is a destabilising influence upon the macroeconomy.

The monetary policy announcement of today is in the context of the following facts. One, India is much more part of the global economy today 8212; both in terms of trade and capital movements. The Indian economy will be facing a slowdown if the global economy faces a slowdown. Further, the exchange rate is not freely flexible. The politicians will not allow a rupee appreciation. In that case, the local interest rate cannot be different from that of the US. If our interest rate is higher, capital will flood in, generating pressure for appreciation. Once the rupee-dollar exchange rate is sought to be controlled by the government, it loses control of the interest rate.

In light of the above facts, it makes sense for Dr Reddy to announce a rate cut in today8217;s monetary policy announcement. This will address the problem of the pressure on the rupee to appreciate and the slowdown which may be caused by a negative global shock. Cutting rates fits both considerations 8212; rupee appreciation and growth slowdown.

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While there is a clear answer for the short run, the deeper problem remains unresolved. How can monetary policy in India be designed to stabilise the economy? Pegging the exchange rate involves giving up the lever of monetary policy. This is a poor choice for India. It is a better strategy for India to use the lever of monetary policy to stabilise the economy, rather than stabilising the exchange rate. Stabilising GDP benefits every household and firm in the country, while stabilising the exchange rate only benefits a few firms and their employees.

Similarly, questions need to be asked as to how fiscal policy in India can be re-engineered to stabilise the economy? This requires looking beyond the FRBM Act as constructed at present. A new framework needs to be put in place, to achieve greater fiscal soundness than the FRBM Act aspired for, and to put in place a mechanism to vary the fiscal deficit over the business cycle.

The writer is senior fellow, National Institute of Public Finance and Policy ilapatnaikgmail.com