The Nineties nightmare

Just as it had in the middle of the last decade, is policy again nudging India into recession?

The current round of inflation and the responses of the government appear to be an action replay, in slow motion, of the policy disaster that led up to the industrial slowdown of the mid-8217;90s. That was India8217;s first encounter with the difficulties of having an open capital account, a pegged exchange rate and an attempt at controlling domestic inflation. The RBI, which often likes to repeat how well its macroeconomic stabilisation policies have served India, messed up badly. When its dollar purchases led to high money supply growth and high inflation, the RBI sterilised its foreign exchange intervention through a series of hikes in the Cash Reserve Ratio CRR and interest rates. Credit growth was squeezed till the growth of non-food credit fell to less than 15 per cent. Not surprisingly, industrial production, which had been growing at double digits, fell sharply. So much so that in January 1997, the Index of Industrial Production witnessed a mere 1.5 per cent annual growth. Following the excessive credit tightening, Indian industry lost its growth momentum and witnessed single-digit growth for a decade.

Is the current monetary policy likely to apply brakes to India8217;s growth story? In recent months, a story similar to that of the mid-8217;90s appears to be taking shape. When RBI dollar purchases resulted in high reserve money growth in the mid-8217;90s, it was unable to sterilise them through open-market operations since the government bond market was undeveloped. In recent years, the RBI has found it easier to sterilise its forex intervention due to a better government bond market. However, as in many other countries that undertake the path of sterilised intervention, when the policy is followed for a long period of time, it becomes increasingly difficult to make the banking system hold more and more government securities. Instruments like the CRR, the share of deposits that banks have to hold with the RBI, are sometimes used and interest rates are raised. The hikes in the CRR that have been undertaken in recent months have, as desired, resulted in a reduction in credit growth. The question is, what might follow next, and is the government sure it wants to make this policy choice?

It is useful to revisit the events of the mid-8217;90s. In 1993-94, India embarked on liberalisation of portfolio inflows. From near-zero levels, portfolio inflows rose sharply to 307 million in the 2nd quarter of 1993-94, and to 2,283 million in the 4th quarter. This marked the beginning of a capital surge into India. From 1992-93 to 1993-94, net capital inflows rose sharply from 2.9 billion to 9.6 billion. Faced with the capital surge, the RBI chose to prevent the rupee from appreciating. The rupee-dollar rate was kept largely fixed during this episode. Between July 1993 and December 1993, the USD was fixed at Rs 31.42. In January 1994, it moved to Rs 31.37. The purchases of dollars by the RBI led to a rise in net foreign assets. Faced with high growth in reserve money, the RBI raised the CRR in order to reduce money supply growth. The CRR became one of the main instruments of squeezing money out of the system. So, on June 11, 1994, it was raised from 14 per cent to 14.5 per cent. On July 9, 1994, the CRR was again raised, to 14.75. On August 6, 1994, the CRR was again raised to 15 per cent. Further, on October 29, 1994, the CRR for Foreign Currency Non-Resident FCNR Accounts was raised from 0 per cent to 7.5 per cent. On January 21, 1995, the CRR for FCNR accounts was raised further to 15 per cent.

As a result of these steps, while reserve money growth continued at 30 per cent, broad money growth was brought down. However, owing to the strong measures taken, bank-lending rates rose above 20 per cent. Industrial growth fell sharply in a few months and was limited to single digit numbers for nearly a decade. Since inflation created a political urgency, policy-makers could not wait for monetary tightening to play out. Several severe measures taken in quick succession, leading to a sharp and sudden tightening of credit, pushed industry into a recession.

In the present episode, sterilised intervention was smooth and easy till January 2004. Since then, interest rate hikes began to be used in trying to reduce the liquidity being injected by the RBI8217;s dollar purchases. The first of the interest rate hikes was in October 2004. The reverse repo rate, the rate at which the RBI borrows from banks, was raised from 4.5 to 4.75 per cent. In October, the repo rate, the rate at which banks borrow from the RBI was raised from 6 to 6.25 per cent. Through a series of steps both rates were raised until March 2007, when the repo stood at 7.75 and the reverse repo at 6.0. At the same time, a large amount of liquidity was being sucked out through the sale of Market Stabilisation Scheme bonds which now stand at Rs 1.7 lakh crore. In December 2006, the CRR hikes began. The CRR was first hiked from 5 to 5.25 per cent. After that, a number of CRR hikes have taken it up to 8.25 where it now stands. This has resulted in a reduction in the growth of non-food credit to 22 per cent in March 2008, down from 31 per cent in December 2006.

However, in April 2008, the RBI8217;s net foreign exchange assets grew at a whopping 50 per cent over the last year. If the RBI continues to pump liquidity into the system like this, it will need many more CRR and interest-rate hikes before inflation comes under control. This could easily, as we have learnt from the events of the mid-8217;90s, lead to a sharp industrial slowdown. The policy of keeping the rupee weak may help some sections of industry, but surely the government must look at the broader economic consequences of the policy, and learn lessons from similar mistakes made in the past.

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

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