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Friday, January 28, 2022

Liquidity self-traps

India’s growth story in the last 15 years has ridden on the back of the middle income group and the affluent.

Written by Vinay Bharat Ram |
April 16, 2009 9:59:59 pm

India’s growth story in the last 15 years has ridden on the back of the middle income group and the affluent. They numbered 150 million in 1995 and exceed 275 million today. This is the result of the “trickle-down effect” that John K. Galbraith so colourfully described. (Paraphrased,he said that while the rich ride in the comfort of their horse-drawn carriages,what trickled down the horses’ legs is meant to reach the poor.) Eighty per cent of India’s not-so-rich,sad to say,will have a long wait for the trickle-down to reach them,thanks to the global crisis of 2008. 

Yes, India’s export dependence is moderate,partly because of a managed float on its currency; but even so,given crisis-hit,declining foreign markets and a domestic slowdown,India must revisit the 275 million citizens who have been the engine of its growth story. They account for the consumption of cars,two-wheelers,the whole range of white goods,of houses and an assortment of services. These,in turn,are backed by manufacturing,infrastructure and commodities like steel and cement. Ultimately,consumption and employment are two sides of the same coin. Both sink or swim together — and both are sinking.

To combat this we would have to confront a trade-off between pump-priming by the government and the creation of more liquidity in the system. The government in the last six months has borrowed massive funds from the Reserve Bank of India to stimulate the economy. Unfortunately,despite the fact that the FIIs have pulled out close to $15 billion and correspondingly injected rupees into the banking system,there is a significant crowding out of private borrowing. According to the RBI,this is the reason why interest rates cannot be reduced.

Let us look at ground realities. To ease liquidity,the RBI has reduced the repo rate to 5 per cent and the reverse repo rate to 3.5 per cent. The prime lending rate (PLR) of public sector banks continues nevertheless at 11.5 per cent,and of private banks at 12.5 per cent. Consequently,since the inflation rate is heading towards zero or below,the real interest rate is a hefty 12 per cent plus. This should cause alarm bells to ring. In the years of high growth,when the inflation rate averaged 5 per cent and the PLR 11 per cent,the real interest rate was around 6 per cent. In most advanced economies it is 2 to 3 per cent. What does this mean? It means that unless money is made available to consumers on easy and sustainable terms they will not be able to buy the output of industry. And unless credit is available to industry at low rates,it will be unable to fill existing capacity,leave aside invest in expansion and employment. The truth is that much of the manufacturing industry today is operating at 50 to 70 per cent of installed capacity and many are uncertain of retaining their jobs. 

The magic number to aim for therefore should be a 5 per cent real rate of interest. The hitch,aside from the crowding-out problem,is that the deposit rate in banks is around 8 per cent. If they lower the lending rate they fear that deposits will migrate to the postal and other small-savings accounts where the interest rate is 8 per cent or higher. To ease the problem,the RBI can to some extent subsidise banks by paying an interest on the CRR deposits,as is the practice in many countries. Furthermore,the government can exempt tax on the interest earned on bank deposits so that banks can reduce deposit rates without adversely affecting depositors. In a sense,this is no different from a fiscal stimulus: both steps will enable the banks to reduce the lending rate. 

Finally,there is no gainsaying that imaginative initiatives are needed to increase production and consumption in the economy. Fortunately,our entrepreneurs have not lost what Keynes called “animal spirits”. This is evident from industry’s brave attempts to raise productivity in the face of adversity,as well as its innovative sprit — so poignantly symbolised by the Nano car and its ancillary support base. Likewise,consumers’ upbeat attitude is seen in their enthusiasm for IPL matches. This is in stark contrast to the liquidity crisis during the Great Depression when at a point in time there were no takers for money even at zero interest. (Keynesians describe this as a ‘liquidity trap’.)

We face a liquidity trap of our own making. There are plenty of takers for money and the banks are flooded with liquidity but a lack of imagination and misplaced caution on the part of our policy-makers prevent the two from coming together.

The writer is an industrialist and economist

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