Case (or not) for policy loosening in India

As we have come to expect from R. Jagannathan (alias Jaggi), he does not hesitate to question the policy orthodoxy or extant economic wisdom.

I am referring to this piece in Swarajya. I have had an email exchange with him on this. A debate is needed on this.

Personally, and in a theoretical sense, I am somewhat neutral to even sympathetic on this issue because there is empirical evidence to argue that

(a) Sustained inflation above 10% are bad but sporadic inflation bouts exceeding 10% do not cause lasting growth damage. Further, as Srinivas Thiruvadanthai (Levy Forecasting Institute in NY) would say, an inflation target of 7% would do no harm. There is no evidence that 4% is sacrosanct and a theoretically carefully chosen number. There is no magic to that number or the 2% number that developed countries have adopted. Until now, that is.

(b) There is a famous speech by the RBNZ governor last year (October 2015) in which he questioned whether central bank monetary policies influence inflation expectations, based on an empirical paper. His speech was based on this research:

I just finished reading the paper by Kaushik Basu (former CEA to the Government of india) written in August 2011. Worth a read. He also mentions the tenuous link between inflation rates and economic growth briefly.

Also, there are times when a higher interest rates improves supply of credit and leads to more credit being made available to the economy than the other way around.

Here is the link to Dr. Basu’s paper.

In the mid-1990s, Michael Bruno and William Easterly have written about inflation and growth, examining both cross-sectional and temporal correlations. The evidence is weak.

In other words, there is a need to make the case not loosely (pun intended) but rigorously, citing academic literature with empirical evidence. Foregoing is a sample.

Notwithstanding the above evidence that weakly (or, otherwise) support a case for monetary loosening in India, we need to take the Indian situation and context into account:

(1) Inflation and the poor and electoral and political noise with inflation. Does higher inflation work in India or does it hurt India? Is it also politically unrewarding for the ruling dispensation?

(2) Inflation expectations are already high  – close to 10% – will another does of a higher inflation propel it higher further? Salary increase demands and competitiveness considerations will follow.

(3) Whether we like it or not – I do not like it – financial markets matter. So, if a policy loosening is interpreted by the market badly, with implications for bond yields (higher) and a weaker rupee, then the purpose will be largely lost.

(4) On credit growth in India, it is a fact that private sector banks’ credit growth is running at 25.7%. See here. This is data through March 2016.

So, where is the evidence that higher interest rates are a deterrent on credit growth? The real issue seems to be PSU banks’ balance sheet and corporate balance sheets.

So, is the answer in lower interest rates or in expediting PSU bank reforms including recapitalisation, consolidation and even privatisation?

If corporate balance sheets are stressed, capital formation will be a casualty. It is inevitable. The economy has to wait it out. Is lowering interest rates the answer or will it boost only more personal loans (growing at 20%), higher consumption, higher
aggregate demand and hence, higher inflation, without helping capex revival?

For credit growth to different sectors, refer to the table 177, Handbook of Statistics (real-time). Data through May 2016 are available. Personal loans are growing at 20% annual rate.

(5) Mudra loans: They may not be the answer to corporate balance sheet stress and lack of loans to medium and large industrial borrowers. They have grown exponentially in the nine months up to March 2016. But, do they work or are banks simply re-labelling existing loans into Mudra loans? How is its economic impact measured? Without having a framework for measuring their economic impact in place, pushing these loans might amount to wastage of resources.

So, to sum up, if we wish to influence policy for the better, I stress the following:

(1) State hypothesis
(2) Marshal literature and evidence
(3) Keep Indian context in mind
(4) Beware of the law of unintended consequences (e.g., financial markets).


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