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S. Venkitaramanan

Unconstrained by monetarist dogma, the RBI's recent Report on Currency and Finance has been brave enough to bare the difficult choices before the country. It is realistic in regard to the problems posed by fiscal stress and in advocating such options as higher monetisation — options that, alone, can help release the economy from the stranglehold of deflationary pressures, unemployment and lower growth.

IN MANY respects, the RBI's Report on Currency and Finance for 2000-01 is a welcome departure from some of its predecessors. It is frank in its discussion of the alternative policy options before the country, especially in the current conditions of low growth and investment pessimism. While the report has done its traditional job of competently surveying the essential features of the macro-economic performance — particularly the deceleration in the growth rate — it has received considerable attention because of its focus on the need for action to reverse the slowing down of the economy. While the earlier reports focussed on reducing inflation, the latest report comes to terms with the reality of the deflationary trend

The report views the threat of deflation set in its global perspective, especially in the light of the Japanese experience and the threat of the European Union falling into the same vicious cycle. To quote: "A situation of persistent deflation can set off a spiral of decline in activity, deflationary expectations, zero interest rates and an ineffectiveness of monetary policy — what has been termed as the `liquidity trap."

In such a scenario, deflation prompts consumers to postpone their current spending in expectations of a fall in prices in the future leading to decline in demand and further fall in prices, thus generating the deflation cycle. Low or zero inflation makes wages inflexible, as workers' unwillingness to accept a cut in nominal wages increases the real wage burden to the entrepreneurs, prompting them to prune their work force and deepening the recession.

It also makes interest rates and other financial prices rigid, rendering the relative price signals ineffective as interest rates cannot fall below zero (negative) and, hence, real interest rates remain high. Moreover, deflation increases the real debt burden, causing bankruptcies and bank failures.

This discussion is of particular interest, especially since as per the latest figures India's inflation rate has fallen to as low as 2 per cent. The RBI's report brings up the concept of a "sacrifice ratio", which represents the sacrifice of growth in pursuit of reduction of inflation. As the report points out, "The current disinflation cycle has generated considerable scepticism about the primacy and, in some cases, the single-mindedness of monetary policy pursuing inflation".

Falling prices may lock into a spiral of economic decline. "It stands to reason to expect a point beyond which attempts to reduce inflation would necessitate a reduction in output. In other words, a sacrifice of output appears inevitable in the pursuit of inflation reduction". Experience shows that as the inflation level decreases and structural rigidity increases, sacrifice ratios may themselves increase and lead to higher unemployment as firms would be forced to adjust downwards. A tightening of monetary policy would then have stronger real effects than in the past.

The evidence cited by the report for 19 industrial countries shows that while inflation rates fell from 8 per cent to 3.4 per cent, sacrifice ratios increased from 1.5 per cent to 2.5 per cent. The sacrifice ratios also depend on the speed of adjustment, with gradual disinflation leading to a higher sacrifice ratio. The increase in sacrifice ratios is relatively lower in countries that undertook measures to increase labour market flexibility.

Effectively, the report highlights the fact that fighting inflation can sometimes become a costly exercise in terms of output loss. The sacrifice ratio for India is estimated to be almost 2 over the period 1975-2000. That is, in the current lower inflation environment, a further reduction in inflation rate by one percentage point could reduce the output by two percentage points from its potential level. There is, of course, a threshold level of inflation below which the sacrifice ratio becomes particularly important. This level is estimated to be 5 per cent for India. Dropping of inflation below this level has serious costs in terms of reduction of gross domestic product.

While the report frankly lays open the dangers of deflation, it offers limited insights into the policy options for breaking this vicious cycle. Surveying the debate on monetary policy, the report concludes that there is little scope for further increase in monetisation of fiscal deficit. The report points out that monetisation of fiscal deficit has already reached a high enough level. Further, it argues that given the current high ratio of Government consumption to the GDP at 14 per cent, there is little leeway for further increase in Government consumption. The arguments put forward by the RBI in support of this conclusion need further elaboration. The report points out that public investments in infrastructure have a larger multiplier effect than those on manufacturing and may, therefore, lead to more private investments. This is a policy signal, which policy-makers would do well to follow.

The report frankly admits that, in the recent past, unemployment has continued to rise. It is fair to point out that rectification of the investment deficit needs more than an application of fiscal stimulus.

It is equally important to unplug the credit channels. The rate of growth of non-food credit has decelerated substantially in recent years. In an economy like India's, faced by the threat of deflation and decrease in demand, industries find it difficult to sustain production, unless adequate credit is available.

Unfortunately, there is, for various reasons, a fear of lending and consequent inertia in the banking system. This inertia applies not only to fund-based loans but also for non-fund limits, such as guarantees and letters of credit, which banks are increasingly averse to extend to units desperately needing them.

If the economic rate of growth is to perk up, it is necessary for the Government and the RBI to ensure that the credit channels — both fund-based and non-fund-based — are not blocked, and the rate of credit growth restored.

Both industry and agriculture today suffer from lack of flow of adequate credit in all senses of the term. It is fair to stress the need for action on the part of the RBI as it is uniquely in a position to increase this flow of funds. Banks should be monitored by the RBI, not only from the point of view of observing the various prudential norms but also from the contribution of increased flow of credit for productive purposes.

This is a line of attack which, in practical terms, yields quick results, especially in regard to medium- and small-scale industries, which feel the credit gap severely. It is worth recalling that the RBI undertook a recent effort with regard to export financing that bore fruit, but needs to be reinforced.

There is a paradox in the way orthodox economists view the question of investment and its financing. If investment is made in the economy by the private sector, and debt contracted for it, it is accepted as a desirable outlay by purists. But, if the ownership of the organisation making the investment is connected even remotely with the Government, the issuance of bonds to finance the investment is considered to add to the fiscal deficit and is, therefore, held to be objectionable.

If, for instance, a 1,000 MW power plant is set up by the private sector and financed by raising bonds, such as happened in the case of Dabhol, it is considered a healthy form of financial activity. But, if the same facility is set up by a unit linked to the public sector, albeit subject to appropriate cost-recovery conditions, the investment is said to add to the fiscal deficit. This dichotomy in approach is what prevents the Government from following the innovative suggestions a la Dr. S. L.Shetty's article in the Economic and Political Weekly of July 29, 2001. Dr. Shetty had suggested a massive bond-financed investment plan for the infrastructure of India, amounting to Rs.15,000 crore a year or more.

This is especially appropriate as the banks are today overflowing with liquidity. This excess liquidity could be channelled into bonds raised by special purpose vehicles set up to finance roads, railways, bridges and power stations.

Such a massive investment will surely help revive the economy and, more important, lay the foundation for productivity growth. It is worth noting that if the same investment were to be financed by organisations owned by the private sector, there would have been no objection from the pundits of orthodox finance. Why, then, should there be an objection when it is funded by analogues of Konkan Railway, NTPC, NHPC, and the like.

Of course, the outcome depends very much on the pricing policies for energy, roadways and railways. But that holds good in the case of the private investments also. Subject to these pricing flaws being rectified, a massive investment programme for infrastructure is well worth the effort, especially in view of the sacrifice ratio of 2, which has been pointed out by the RBI report.

The Report on Currency and Finance has been brave enough to bare the difficult choices before the country. For one thing, it is unconstrained by monetarist dogma. At the same time, it is realistic in regard to the problems posed by fiscal stress.

There is need to explore further such options as higher monetisation — options that, alone, can help release the economy from the stranglehold of deflationary pressures, unemployment and lower growth.

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