The debate beyond rate cuts

A file photo of RBI governor D. Subbarao. Photo: Abhijit Bhatlekar/Mint

Live Mint :Tue, Jan 29 2013. 01 51 PM IST

As expected, the Reserve Bank of India (RBI) has moved to make money cheaper. The Indian central bank has reduced the repo rate and the cash reserve ratio by 25 basis points each. Governor D. Subbarao has said that this is expected to support growth by encouraging investment and will continue to anchor medium-term inflation expectations. RBI has also cut its gross domestic product (GDP) growth forecast for the current fiscal to 5.5% from 5.8%. Inflation is expected to be at 6.8% by the end of the current fiscal, from the earlier forecast of 7.5%.

Since the much-awaited review of the monetary policy is now out of the way, the markets will get back to analysing whether this rate cut will help revive investment activity and boost growth, in light of the fact that inflation is expected to remain above the central bank’s comfort level. Subbarao, in his statement, noted: “There is an increasing likelihood of inflation remaining range-bound around current levels going into 2013-14. This provides space, albeit limited, for monetary policy to give greater emphasis to growth risks.”

It is becoming increasingly important that limitations to monetary policy to stimulate growth are accepted. If the Indian economy is to revive in a sustainable manner, corrections need to be initiated at the fundamental level.

There are two major impending challenges in the macroeconomic management of the country—reviving economic growth and managing the current account. On the one hand, it is important to revive economic growth, which will enhance investor confidence, create employment and help the government raise revenues in order to bring back its books in order. On the other hand, there is an urgent need to contain the current account deficit (CAD), which has significantly raised the dependence on the international capital flows. CAD reached a high of 5.4% of gross domestic product (GDP) in the second quarter of the current fiscal and created a gap of $7 billion per month that has to be filled by capital flows from abroad. Although the financing has been relatively easy, the increased dependence and the rising component of debt flows may pose challenges to financial stability in the medium to long run.

A rate cut, theoretically, will help revive consumption and investment demand leading to higher growth. However, a recovery in demand could push up imports and magnify CAD. RBI in its third quarter review of macroeconomic and monetary developments noted: “With the likelihood that CAD/GDP ratio may exceed 4% of GDP for the second successive year in 2012-13, prudence is necessary while stimulating aggregate demand.” For growth, it has been reasoned enough that a rate cut alone will not do much. Lower interest rates, for example, will not help revive mining output, ensure fuel supply at power plants or speed up project clearances—notable immediate challenges in reviving growth.

Apart from the much talked about procedural delays in project implementation, India needs reforms at various levels that will make growth lot more sustainable and also help boost exports. This will also allow RBI to focus on inflation and reduce the burden with respect to anchoring growth and managing currency. A lot can be achieved by correcting the anomalies in the manufacturing sector. The Indian manufacturing sector and, as a consequence, exports from India are heavily skewed in favour of high skill and capital-intensive sectors. This is one of the reasons why the dependence on agriculture for livelihoods has not reduced significantly, and India is missing on the opportunity in exports of labour-intensive sectors such as textiles.

One of the reasons for this anomaly, as underlined by economists Jagdish Bhagwati and Arvind Panagariya in India’s Tryst with Destiny: Debunking Myths that Undermine Progress and Addressing New Challenges (2012), is rigid conditions in the labour market, which have not allowed large-scale labour-intensive sectors in the country to develop. The two economists note: “The true explanation lies instead in the fact that additional layers of regulations and barriers remains to discourage the emergence of large-scale labour-intensive manufacturing in India. The dominant cause is highly inflexible labour market, which makes the cost of labour in the formal sector excessively high.” According to a study by the Asian Development Bank, Enterprises in Asia: Fostering Dynamism in SMEs, published in 2009, only 10.5% of the workers in the manufacturing sectors in India were employed in firms with more than 200 workers. The ratio for China was at 52%.

Clearly, India is not only losing on the exports front, but also on the opportunity to create mass employment which will push growth and make it lot more sustainable. Consequently, labour-intensive manufacturing activities that are shifting out of China because of rising wages, though China still maintains dominance, are flowing to smaller countries such as Bangladesh and Vietnam instead of coming to India.

The debate on returning to a sustainable higher rate of growth, therefore, needs to broaden.

 Yes, interest rates and the cost of capital is important,

 but it is still a necessary but not a sufficient condition 

for attaining growth and prosperity