Economic laws for India

There is scant evidence that low or even negative real rates of interest channel investments into needed sectors

As the country awaits the announcement of a new governor for the Reserve Bank of India and the new monetary policy committee, I thought it would be best to apprise them of India’s uniqueness that makes raising interest rates in India unnecessary. They have to decide only on the timing and the magnitude of interest rate reductions.

1. Monetary policy cannot do anything about inflation because food inflation is not under monetary policy control.

2. In general, India’s inflation problems are deemed to arise from supply constraints, so there is no need for the central bank to tighten policy at all.

3. India’s fiscal deficit does not matter because the Indian government borrows from Indians.

4. Indian banks do not have to worry about non-performing assets because they have more than 20% in government securities.

5. India should have lower interest rates all the time because it would boost investment and alleviate supply constraints.

6. Indian real estate prices can keep rising and will never come down because India has demand all the time. Considerations like affordability ratios do not apply to India and because property prices should always be going higher, do not raise interest rates.

7. In India, higher interest rates will mean wider fiscal deficit because the government’s interest rate burden would rise, because the government will never reduce its market borrowing. Therefore, do not raise interest rates.

8. India can have a combination of lower interest rates, high inflation and cheap currency because India is unique.

9. India can simultaneously have a combination of low interest rates, high inflation, high growth and stable current account balance without any problem because India is different.

10. Savings rates stagnation does not matter for India’s growth because India is India. Therefore, there is no need to raise interest rates.

11. India can simultaneously engage in loose monetary and fiscal policy and the Indian currency would remain unaffected. Foreign direct investment will keep pouring in because the world has no option but to invest in India. Therefore, no need to raise interest rates.

12. Notwithstanding anything said above, we also believe that India is a middle-income country and it is the world’s fastest growing large economy.

13. We are Indians and we are different and hence we can simultaneously believe in all of these without any fear of contradiction or consistency of logic.

Let us get serious now and tackle some of these fantastic claims. Every developing economy would have some supply constraint or the other. In fact, it could be several supply-side constraints. In fact, if anything, it makes the case for demand restraint more urgent and important than less. Therefore, it does not make monetary policy irrelevant but more relevant.

Second, the implicit argument is that higher interest rates that are aimed at restraining demand in the face of an economy operating under supply constraints is that such a policy restrained the economy from alleviating or removing the supply bottlenecks. Unfortunately, the evidence is scant that low or even negative real rates of interest channel investments into needed sectors.

That is why I added the 12th point. We cannot argue that our consumer price index is dominated by food as is typical of a poor country and yet claim that we are one of the world’s top economies on purchasing power parity basis. We have to choose one of the two.

On (3) above, a domestically funded fiscal deficit is not immune from external shocks because of the national income identity. (S-I) + (G-TR+TP) = X-M where TR = government transfer payment and TP = tax payments to the government and G is government spending. Private sector savings - investment balance and government budget balance = external balance. The above identity follows from the basic National Income Identity.

This is particularly relevant for India with a chronic current account deficit. We have both terms on the left in deficit. So, it cannot be open-ended merely because it is internally financed. Contrary to the assumption made by Dani Rodrik and Arvind Subramanian in their paper: Why India Can Grow at 7 Percent a Year or More: Projections and Reflections (2004) that our savings rate would rise towards 40% of gross domestic product, under the old base year of 2004-05, it had gone below 30% and under the new base year is stuck at around 33%. The historical time-series of the savings rate under the new base year is not out yet. Therefore, the higher the fiscal deficit, the wider the overall internal savings deficit and dependence on external savings with all the attendant vulnerabilities to the vagaries of external capital flows.

Even China did not play by its rule for the first 20 or 25 years of its economic reforms programme. Now that they have acquired heft, they are trying to write their own rules. In contrast, a country that is prone to stagflation and external imbalances with stagnant domestic savings does not have the credibility with the market to write and play by its own rules.

Hence, calling for fiscal and monetary loosening is downright suicidal. India is a long way off from being able to pull off such things without the economy suffering real consequences via the currency and bond yields.