Suggestions for managing growth

Last fortnight we had sought to highlight the dual role of bank credit in this country and the need to ensure finance for creating additional productive capacity while squeezing the froth that inevitably rises in an effervescent economy. There was a quote that had got left out due to constraints of space and is worth repeating.

Chairman Ben Bernanke in his 28 March 2007 testimony to US Congress had suggested that core inflation was above the safe limit, stating that the “predominant policy concern remain(ed) the risk that inflation will fail to moderate as expected” – after 33 months of tightening. The problem is not that inflation has somehow become impossible to handle, it is just that the job has just got tougher.

This is a period of great challenge and opportunity. Much will change in terms of economic and political balances over the next couple of decades and how well we rise to the occasion is going to be mostly determined by ourselves. If we manage to maintain growth with monetary and price stability, consolidating past gains on fiscal and financial strength, we will come out greatly stronger-both in absolute and in relative terms. Other less desirable outcomes are also possible.

On the monetary front, the central bank’s intervention in the second half of 2006-07 has served to re-price banking loans. Across terms and credit quality, lending rates have risen significantly. Of prime importance now is not so much the interest rates, but absolute liquidity. This is a direct consequence of having a capital account surplus of $50 billion and a current account deficit of $10 billion. It is no doubt tempting to dream that a reset of exchange rates will alone serve to bring balance.

The fact is that our great northern neighbour still has a currency that is pegged to the US dollar and even as it takes micro-steps to appreciate against the greenback, it depreciates against the other major currencies. Not withstanding having a current account surplus of $250 billion, huge capital inflows and foreign currency reserves of more than $1 trillion, the renminbi has appreciated 3.5% vis-?-vis the US dollar over the past year, while the Indian rupee has risen by 5.1%. China ‘s export volumes are many times ours and in most merchandise markets her share is typically more than 10 times that of ours. The only sector where we compare favourably is IT/software.

It is thus remarkably naive to dream that exchange rate adjustments alone hold all the answers for us. Our businesses live and breathe in this world and have to survive the competition. We are price takers; we have to stay afloat in the wake of the Chinese leviathan. While some appreciation is possible to accommodate-forcing greater efficiencies out of our enterprises, enlarging the current account deficit and enhancing our ability to absorb foreign savings – too much (the amount needed to equilibrate the current and capital account balances) would cause structural damage. It might make for some interesting academic analysis later?but that is not the purpose of policy making.

The problem with intervention is that it creates high-powered money, and does so at a pace that is dictated by uneven peaks in capital inflows. The cheap way (both literally and figuratively) is to swap dollars for rupees and hope that the new flood of rupees is absorbed by the system without fuelling inflation. An economy that is growing has a need of larger money balances and a fair amount of non-inflationary absorption is possible. If the monetary effect of the intervention in the foreign exchange market is to be neutralised, the central bank can sell government bonds and treasury bills in like quanta – a process called sterilisation. However, sterilisation has a cost, namely the interest on the bonds/T-Bills that the Government of India bears.

But for an economy that is growing rapidly with incipient inflation always waiting to flare up, that is a cost that needs to be borne. While it is presumptive to write prescriptively, in this case it is unavoidable. The central bank should neutralise all of its interventions one-for-one with Market Stabilisation Bonds (MSB). Liquidity management should be guided by the amounts that banks are borrowing at the repo window. If it is excessive, resort to open market purchase of MSB, and vice versa if banks begin to line up at the deposit window. Quite obviously the liquidity management response will be then timed by the needs of the loan market and not that of unrelated capital in-flows.

Finally, however tempting it might be, the central bank must not suggest that it is willing to live with a higher rate of inflation. The earlier target of 5.0% to 5.5% was itself on the higher side considering the much lower inflation prevalent in our competitor and market countries. It is true that the overhang of inflation is unlikely to bring it down to much below 5.5% in the next 3 to 4 months; however, remember that there are many risks?from monsoon to oil price prospects ?which can easily push it back over 6%.

Getting to 5.5% is not safe haven and to even suggest that it is so is to court danger. If we keep things tight, working the headline inflation rate back to 5% and lower in the second half of 2007/08 is distinctly feasible and consistent with not impacting growth over-much, except that arising from leveraged retail finance. This outcome is something that we must try and bring to fruition.

?The writer is economic advisor, Icra