Balancing bars for a higher tightrope

Written by Saumitra Chaudhury | Updated: Jan 22 2007, 05:30am hrs
The RBI in its Annual Policy Statement for 2006-07 in April 2006 had observed that "growth in money supply in 2005-06 was above the trend". Economic growth in 2005-06 and in 2006-07 has been stronger than what the central bank (and all of us) had initially expected. To the extent that acceleration of growth consumes liquidity in disproportionate quanta, money supply expansion that is above the historical trend may well be expected. Further, compared to other emerging economies, the level of monetisation measured by ratios of broad money or bank credit to GDP is comparatively much smaller.

The trade-off between economic growth and inflation (or between unemployment and inflation) has been a staple of discussion for long. Experience has demonstrated that stable monetary conditions (meaning low inflation) makes for vastly superior conditions for stable growth and generally orderly conditions in all markets, including those for financial and other assets. In addition, increasing global integration, which offers new growth opportunities, also demands stable domestic financial conditions to make the most of such opportunities. Inflation that is significantly higher than that of other trading partners erodes the competitiveness of domestic producers.

Matching depreciation of the currency can compensate for the loss of trade competitiveness, but it brings about a decline in the incomes of the populace, measured by prices of trade goods and services.

In our specific instance, favourable economic conditions at home have drawn foreign investment, and the net capital flows are larger than our current account deficit, courtesy our hard-working brethren who work overseas and remit money home to their families. In order to prevent rupee appreciation, the RBI has had to buy and accumulate large foreign currency assets.

While the Indian rupee has in nominal terms lost 32% of its value, it has however become 5.8% more expensive, once the differences in inflation rates are factored out
The Real Effective Exchange Rate (REER) is an index that measures the movement of the external value of the rupee vis--vis that of Indias major trading partners; the most commonly used one is the six-currency index. In mid-December 2006, tells us that while the Indian rupee has in nominal terms lost 32% of its value, it has however become 5.8% more expensive, once the differences in the rates of inflation in India and other countries are factored out.

Indias exports of both goods and services have been growing at a fairly rapid clip. Export of merchandise is expected to expand by 22% in 2006-07 and that of services (software and BPO) by a similar order. That these sectors are able to achieve this degree of export growth despite the loss of competitiveness on account of real appreciation of the exchange rate, may be attributed to productivity gains. On account of the real-but-not-nominal currency appreciation, some of these gains accrue to importers of these goods and services, rather than being retained by Indian exporters. The only way to contain this effect is to bring domestic inflation more-or-less in line with that of our major trading partners and especially those in the emerging world who are both our partners in trade as also the competition. It is for this reason that a target of 4% annual inflation was put forward as the first step, with a 3% rate as a possible medium-term objective.

Till January 5, 2007, broad money (M3) increased by 11.9% in 2006-07, compared to 8.8% in the corresponding period of the previous year. The growth of bank credit to government (4.4%) and to the commercial sector (15.4%) was only marginally higher than in the corresponding period of the previous year. The difference came from net foreign currency assets which expanded by 14.0% during this period in 2006-07, compared to 1.8% last year, or 7.1% if the impact of India Millennium Deposits is excluded. Thus the contribution of foreign currency reserve accretion to broad money growth was twice as large in 2006-07, relative to the corresponding period of last year. And despite all this energetic intervention, the rupee has appreciated in inflation-adjusted terms. Which then brings us back to the importance of restraining inflation. On the monetary side, there is real economic growth happening and domestic financial resources need to be channelled in that direction. If not, larger investors will simply go to overseas markets and incur foreign currency liabilities which, when brought back to acquire rupee assets, will further add to the difficulty of managing the problem. Tightening interest rates does improve the efficiency of asset allocation and should serve to contain the expansion of consumer credit, more than it does that which arises from industry and infrastructure but there are limitations on how far the process can go.

Government tax revenues have been favourably strong and a decline in government demand for finance can improve the liquidity available for private sector growth without effecting money supply. Curtailment of import protection to industry can help reduce the price pressure from a host of commodities, where in an environment of strong demand and tight domestic supply, prices are being set on import parity basis, which includes customs duties. The reduction in the statutory liquidity ratio (SLR) for banks should help them manage their asset side better, while moving the main source of financing of the government debt somewhat away from banks to insurance companies and pension funds. Steps need to be taken to ease existing supply bottlenecks in the domestic economy both in agriculture and infrastructure such that cost escalation does not exact too heavy a price on the eminently favourable prospects of strong and sustained economic growth.

The writer is economic advisor, Icra