It has to be understood that growth is a slow process and cannot be achieved by either cutting the repo rate by 100 bps or increasing the fiscal deficit by 1%
Are there limits to policy-induced growth? This question is in the air even as the debate over the efficacy of monetary policy and fiscal policy is still ongoing. In fact, when the financial crisis and its aftermath is examined, it does appear that notwithstanding the efforts made by governments and central banks, the world economy has not yet regained the robustness and confidence that existed prior to the crisis. Even China is struggling now and the policy of building more roads and trains helped to a large extent but has subsequently led to stagnation when consumption has lagged. The lesson is there is no quick-fix solution for growth; and, counter-intuitively speaking, if such a solution was there, it would have been used by now and there would be high growth everywhere.
Therefore, if one looks at India and the role of monetary policy, the feeling is that we are expecting too much from the repo rate. The government, corporates and the media have always been nudging RBI in different decibel levels to keep lowering the repo rate as if it were the ‘be all and end all’ for our travails. While critics tried to link policy with the Governor’s preferences, this issue has also been addressed by having the MPC, where 6 members decide on the course of the repo rate and, so far, the majority has thought the same. Therefore, there is no individual bias involved in decision taking here.
Now, a common argument put forward is that banks have been slow to react to repo rate changes. This is the classic case of the transmission mechanism being sluggish. How far is this true? The data from 2001-02 to 2018-19 has been put together and the coefficient of correlation between the two i.e, changes in repo rate and changes in PLR or base rate have been mapped. The relation is actually strong at 0.65. Therefore, to say that banks have not been reacting positively is incorrect. Correspondingly, a secondary argument is that the quantum of response has been lower than that of the repo rate. Since the base rate and MCLR are both formula-determined, banks have to first change the deposit rate and then the lending benchmark rate changes accordingly. Banks have a conundrum. When deposit rates are changed, it is only incremental deposits that are either new or renewed ones that are subject to the new rates. In case of loans, most of them get re-priced at the new interest rate. Therefore, the quantum of reduction in deposit rate tends to be higher than that in lending rate.
Another interesting statistical relationship is that between change in rate of growth in credit and change in repo rate. It is low at 0.10 but positive which is against what theory dictates. The explanation is not hard to put together. Lowering the rate is just one part of the story where supply of funds is made cheaper. Firstly, even on the supply side, enough liquidity should be there or else it gets rationed out and here the government borrowing programme can be a ‘crowding out’ factor. Banks, too, have been cautious after the NPA debacle and have been cherry-picking clients and, hence, would not lend to companies where the NPA ratio is high. Retail lending has tended to benefit more from rate cuts.
Secondly, the demand side is important for growth in credit to take off. Here, some of the higher rated companies have accessed the bond market to raise funds. Further, with capacity utilisation rates being in the region of 70-72% (of late it has increased to 75%), there has been less reason for companies to borrow for investment. Most of the borrowing is for working capital and a number of companies have been deleveraging given the low growth conditions in the economy. Therefore, for growth in credit to take place, both demand and the willingness and ability to lend must increase. This is why there is a gap between interest rate action and growth in credit.
If monetary policy has its limitations, can something be done? In the US, followed by the Eurozone, unconventional policies have been followed like central bank purchases of non-government bonds. If supply of funds is an issue (which is not the case as RBI has been proactive with OMOs and LAF), can RBI think of lending to banks against corporate loans (corporate bond repo already exists).
The Keynesians argue that government spending is the way out and that we should pay less regard to the FRBM as it unnecessarily chokes up policy options. The point made is that the government should expand on the deficit which was what was done when there was the financial crisis in the west. In fact, at that time, the repo rate was reduced and the deficit then increased. This can become a part of the policy—so goes the argument.
A regression where GDP growth is mapped to both a change in repo rate and the level of fiscal deficit ratio from 1991-92 onwards gives some interesting insights. The overall explanatory power is reasonable (coefficient of determination) at 0.38. However, both the explanatory variables have a negative sign with the change in repo rate being ‘not significant’. This means that while the decline in repo rate leads to an increase in GDP, the relation is not significant. In case of fiscal deficit, the coefficient is significant but goes with a negative sign, thereby meaning that a higher fiscal deficit leads to lower growth. Is Keynes wrong then?
Keynes had given the solution of fiscal expansion only for a recession when there is a glut as people do not spend and the only way out is to have the government spending. But India has not been in a recession which is defined as negative growth in two successive quarters. GDP growth has slowed down at times but has never been negative. Therefore, the efficacy of Keynes is strong when there is a sharp slowdown in growth. Otherwise, it could have a negative impact insofar as crowding out the private sector and pushing up effective interest rates is concerned.
What then is the solution? It has to be understood that growth is a slow process and cannot be achieved by either cutting the repo rate by 100 bps (as some economists argue) or increasing the fiscal deficit by 1% (as some Keynesians aver). The economy is led by the private sector and aggression from the government or central bank can have limited impact. In fact, hyperinflation in some countries in Latin America and Africa has been due to unbridled Keynesianism. Countries like China, Turkey, etc, have kept their cost of funds deliberately low to prop up growth which works to an extent, beyond which it becomes impotent.
The government needs to have the right policy framework in place and keep working away at capex in the budget. Central banks have to be cautious in rate cuts and not bow down to pressure. As cricket is the flavour of the season, growth is a five-day match affair, and hitting out wildly in the 20 over format can lead to a situation where all wickets fall before the 20 overs are completed and we run short of policy options.
The author is Chief economist, CARE Ratings Views are personal