Why we should rethink our monetary policy

The Indian economy has undergone diverse stages of makeover, over the years. India was among the better performing countries after the financial crisis period. However, the performance of the economy in recent years has been rather sluggish due to many factors. Currently the Indian economy faces a variety of challenges - not just the global slowdown, with bleak prospects for exports, but also domestic factors that play a significant role.

The IMF recently revised the global growth rate downwards. Amidst the already slow global recovery, the emergence of new risks, such as uncertainties about expectations of withdrawal from unconventional monetary easing by the advanced economies, is a cause of concern to India.

Domestically, almost every macroeconomic indicator has been critical, be it industry, construction or services. The macroeconomic conditions in the country weakened during 2012/13. While growth came down to a 10-year low of five per cent in that year, the first quarter of 2013/14 also indicated a considerable fall in growth, to 4.4 per cent.


The growth scenario is grim. Fast clearance of delayed and stalled projects, despite fierce election battles, would not immediately influence growth, as there is generally a gestation lag. Aggregate demand remains weak, primarily due to slowing private consumption and contracting fixed investment. Various surveys indicate that business confidence remains weak, while expectations of inflation have increased.

Agriculture, which constitutes less than 14 per cent of GDP despite a good monsoon, cannot be expected to significantly influence the overall growth rate. Industrial growth has experienced a near-stagnation situation for the past two years. The main factor in the decline of the overall performance of industrial growth is shrinkage in the mining and manufacturing sectors. The manufacturing growth rate was a mere one per cent in 2012/13. Capital goods production also declined by six per cent during the year, indicating a sharp fall in investment activity. The services sector recorded the lowest growth in 11 years at 6.8 per cent during 2012/13.

The fiscal situation is also grim. Other than collections from customs duties, growth in gross tax revenue has been lower under major heads, as would be expected in a slow-growing economy. The widening of the revenue deficit, together with higher capital expenditure, has added to the gross fiscal deficit, inducing the risk of fiscal slippage. Fiscal slippage is apparent, but given that the government's borrowing costs are lower than last year, despite the rise in average maturity, fiscal profligacy is anticipated in the election year.

External-sector vulnerabilities were also highlighted in 2012/13. India's balance of payments has been under growing pressure, as reflected in the widening of the Current Account Deficit (CAD). The CAD reached a historic peak of 4.8 per cent of GDP in 2012/13, and widened from 3.6 per cent of GDP in the fourth quarter of 2012/13 to 4.9 per cent of GDP in the first quarter of 2013/14. To contain CAD, the government and the Reserve Bank of India have taken stringent measures, especially to restrict gold imports. In the first quarter of this year, the external debt as a ratio to GDP increased, and the reserve adequacy indicators deteriorated.


The rupee has experienced increased volatility in recent months. A sudden surge in capital outflows at the back of the likelihood of the tapering of the US Federal Reserve's quantitative easing programme led to sharp depreciation. Between mid-May and end-August 2013, the rupee depreciated rapidly by 17.7 per cent against the dollar. Improvements in global sentiments helped reverse this trend in early September, and the rupee appreciated by six per cent, and further by 1.9 per cent, up to October 25. However, policy makers understand that any relief due to the postponement of tapering by the Fed is only procrastination, and not permanent respite.

Inflationary pressures are rearing their head in India. Wholesale Price Index (WPI) inflation declined to 4.6 per cent in May 2013. However, due to a rise in food and fuel prices, the WPI again rose to 6.5 per cent in September 2013. Among food articles, vegetable prices were the driving force. Further, the depreciation of the rupee, along with the rise in crude oil prices, brought about a rebound in fuel inflation. Inflation measured by the Consumer Price Index continued to stay near double-digit levels, mainly driven by high food inflation.

To anchor inflation, the repo rate has been raised twice in the last six weeks, intensifying the war on inflation. But will it lead to the expected results? Not likely, because the main culprit in this episode of inflation is the select list of food items, and not just the demand pressures that monetary policy seeks to address. Rather, higher interest rates may not yield higher deposits, as a small proportion of the population saves through banking, while others save in gold and real estate, especially when economic uncertainty is high and the black economy is flourishing.

If global sentiments change, capital outflows would still occur, because of the prevailing economic environment. Thus the hike in interest rates will only stifle growth further, resulting in higher unemployment. Traditionally, any responsible central bank, to safeguard the interests of citizens, would tighten the monetary policy when fiscal profligacy, especially during an election year, is observed. But if it impinges on growth and unemployment - the two other objectives of monetary policy - then the monetary stance probably needs to be boldly revisited and not seen through a traditional lens.

(The author is the RBI Chair Professor of Economics at IIM Bangalore. Views are personal.)