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What the rate will change

Amidst growing demand for a stimulus to re-energise the economy and take it back to the magical 7 per cent-plus growth rate that it had achieved, making India the fastest growing large economy in the world, the RBI has cut policy rates again, for the third time in a row.

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Subir Roy
Senior Economic analyst

Amidst growing demand for a stimulus to re-energise the economy and take it back to the magical 7 per cent-plus growth rate that it had achieved, making India the fastest growing large economy in the world, the RBI has cut policy rates again, for the third time in a row. If similar sentiments continue to prevail, the coming Union Budget will also loosen purse strings to signal stimulation to demand.

But there is a need to step back and ponder whether too much is made of rate changes as a policy instrument, particularly when transmission is poor (you and I don’t quite get to benefit from them), and whether there is a need for such changes right now.

First, if a slowing growth rate still clocks a quarterly growth of 5.8 per cent, allowing the  economy to notch up a highly respectable 6.8 per cent for the entire financial year 2018-19, the need for a stimulus to overall demand requires pondering. This is particularly so when environmental sustainability of high growth has emerged as a key global issue.

The growth rate has slowed across three sectors — investment, consumption and exports. Of these, only consumption can benefit directly from a broad stimulus. Exports and investment typically face sector-specific issues which need focused policy attention. Exports are influenced both by global demand and domestic competitiveness. Addressing them is a complex task and as they are driven by their own dynamic. Global demand, for example, will be affected by US President Trump’s trade war with China.

As for investments, public investment directed at improving the infrastructure can only do good. Private investment will pick up by being crowded in and also when capacity constraints emerge and business sees profitable growth ahead from higher capacity.

The need to be cautious with a blunt instrument like overall budget deficits and policy interest rates to address consumption slowdown is that several factors are simultaneously at play. Most importantly, consumption pickup will push up food prices that are already on the rise and they account for nearly half of the weightage of the consumer price index.

What is more, how satisfactory the monsoon will eventually be is still wide open and after a poor start to the summer season two regions, southern and western, are facing a drought. If stimulus to consumption comes at a time when the monsoon is set to underperform, we can be headed for a sharp rise in food prices which will take upward with it the overall inflation rate.

There is yet another element in the current scenario which needs to be pondered — a hugely unsatisfactory employment rate with unemployment running at a four-decade high. The economy urgently needs to create more jobs but that will hardly come by pleasing the corporate sector which has been asking for a stimulus.

The surest and quickest way to create new and more jobs is to improve the ease of doing business for small and unincorporated businesses. The basic availability of credit is more important to these businesses than its cost being 1 per cent more or less. High-tech investments by large firms create few additional jobs.

The situation that unfocused stimulus can create is a combination of rising prices, high unemployment and anemic growth. These are the elements that make up classical stagflation which visited the US during the seventies. The Keynesian imperative that prevailed then was to increase money supply to promote growth without being over concerned about inflation. But it did not work, what did was Milton Friedman’s notion that inflation was a monetary phenomenon. Conservative monetary policy under Paul Volker, which drove interest rates sky high and brought about the worst post-war recession in the US during 1981-82, eventually brought down inflation.

It is not as if India is headed for stagflation but the combination of elements that lead to it are emerging. A stimulus, be it monetary or fiscal or both, has to be carefully thought out. A stimulus, carelessly applied, almost never works.

The best policy initiatives are those that in one stroke address more than one issue. If the government were to do the one thing that would make a difference, it is to urgently devise a package of measures which will make farming viable again. Not only will it address rural distress, but also positively impact the unemployment rate, reducing the flow of migration to the cities by people in search of jobs.

How do you make farming viable again without initiating an episode of food price inflation? What does not help is waiving farm loans and raising MSPs. The former is like disaster relief and the latter is a fairly useless instrument as most farmers most of the times have to sell at below the MSP. Income support to farmers is in part a welfare measure (it helps relieve distress) and only in part makes it possible for farmers to investment in fertiliser and the like to raise productivity. The way to make farming viable is to ensure that the markup between the farmgate and the fork is reduced, the farmer gets more while the consumer does not pay very much more. The section which needs to lose is the traders in between. The way to move in this direction is to create a single market for agriculture and remove the restrictions imposed by marketing committees.

We need sector-specific solutions, be it for exports or agriculture. Broad stimulus packages can do more harm than good. And if there be deficit financing, let it result from public investment in infrastructure. Across-the-board stimulus, delivered by rate cuts, are neither here nor there.

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