Indian economy is in shambles – few believe this statement to be an exaggeration. There is ample evidence to suggest that, from an emerging and second fastest growing economy in the world, we have reached a stage where macroeconomic parameters reflect the poor state of Indian economy. Rupee is falling and not responding to desperate measures taken by the Reserve Bank of India (RBI), current account deficit is not within manageable limits, industrial growth is completely stagnant and despite efforts inflation, particularly food inflation, is not subsiding. Added to all this is the state of policy paralysis that Indian economy has experienced over last two years or so. We have a government but governance seems to be completely missing as far as economy is concerned.
While there is no denying the fact that a combination of factors, including some of the non controllable international economic factors, have brought Indian economy to this stage of despair – one of the key contributors to the current mess is a series of monetary policy measures taken by the RBI over a period of last three years. I must clarify that it is the issue of policy and not the person. After 2008 crisis, RBI started cutting repo rate to provide necessary lifeline to the growth. On 29th July, 2008 repo rate was 9.00 which went done to 4.75% on 21-Apr-2009 just during a span of 9 months. But then came a sudden shift. And the shift was towards controlling inflation. The bogey of inflation was so overwhelming that RBI activities started giving an impression that people at the helm of affair in RBI were elected representatives . In order to provide the common man respite from ever increasing inflation, RBI started increasing repo rate thinking that inflation is a demand side issue. It was just not one or two hikes that were seen in repo rate but it was a series of 13 rate hikes which again brought repo rate to 8.5%. The RBI completely went wrong here. In India, inflation has been predominantly a supply side constraint and this aspect blunts effectiveness of monetary policy measures.
With every hike in repo rate, the growth started getting retarded as the cost of capital went up. Though RBI has always stated that growth is not linked to cost of capital, the fact remains that small as well as large businesses get hit from the cost of capital. Policy paralysis and international macroeconomic factors added fuel to the fire. Investments started slowing down which had an impact on GDP growth. An economy growing at 9% came back to neo-Hindu rate of growth of 5% . Even individuals started feeling a pinch of a high rate of interest in form of higher EMI and other loan payments.
The credit driven growth of the Indian economy got hit with a series of rate of interest hikes. While RBI thought that rate of interest increases will contain inflation, global factors continued to increase inflation in spite of RBI’s rate hikes. RBI had absolutely no control on global factors such as crude oil prices which is dependent on international factors. RBI attempt to throttle growth at the cost of controlling inflation produced results but it was temporary. RBI subsequently (much later) reduced the repo rate by 125 basis points from its peak of 8.5% but it was too late. The economy refused to take off as investment climate had worsened.
This is not just one case in which the regulator failed the country. The recent fall in the rupee is a classic case. Rupee started tumbling against major currencies of the world. The fall was in rupee was so sudden that it took reactionary RBI by surprise. Rupee crossed 6o mark making the regulator as well as government nervous. War footing measures were introduced by RBI to stop speculation in the currency market, which stifled the entire bond market causing huge loss to banks. Hitherto safe debt market became as volatile as the equity markets causing substantial loss for investors (the risk premiums increased due to this volatility). Rupee did recover and came below 59 but that was temporary – Rupee once again tumbled and crossed 61. All the measures to control rupee failed and investors in the debt markets saw heavy losses. Once again reactive RBI measures failed to produce any desirable results.
RBI handling of Indian financial system has always been praised. But the fact remains that more than RBI’s success it is the plain vanilla structure of Indian financial system that kept India away from crisis. RBI’s activism in initiating monetary policy measures could not bring the desired result because monetary policy alone cannot work as panacea for ills faced by Indian economy. But the problem lies in the ineffectiveness by policy measures but rather in the belief that these measures work in India. Today we at a stage when we can safely say that RBI measures have failed to control inflation but have inhibited growth for sure. ‘Na Maya mili na Ram ‘ best describes RBI’s policy actions.