How Raghuram Rajan’s rate cuts impacted India in 2015

The debate over the state and future of the Indian economy has been rife over the last couple of years, but increasingly, there is a sense that the time to determine the course of its future is now or never. The current government was arguably elected on the mandate of economic reforms and development, but the two most decisive steps have been taken by the Reserve Bank of India (RBI), led by governor Raghuram Rajan.

Earlier this year, a new monetary policy framework, which for the first time sets the agenda of the central bank as inflation targeting (consumer price inflation of 4% with a band of +/-2% from financial year ending in March 2017), came into place. And in September, a surprise rate cut of 50 basis points (bps) was announced, which added considerably to the 75 bps cut made gradually over the course of 2015.

Rajan will announce the fifth bi-monthly monetary policy review on Dec. 1—the last policy of the calendar year—and is expected to keep key interest rates unchanged. In 2015, he cut rates four times.

In this context, Pragya Tiwari spoke to Jayati Ghosh, professor of economics at the Centre for Economic Studies and Planning, School of Social Sciences, at Jawaharlal Nehru University, about the potential of these rate cuts and about the role of monetary policy in the current state of the Indian economy.

Q: Is the new monetary policy framework a step in the right direction? What is your take on the debate on inflation targeting?

Ghosh: I am not a fan of inflation targeting. I believe in a country like India, it’s much more important to have multiple targets, and there have been many studies that have shown that inflation targeting is not very effective, especially where there is a very large informal sector; where there is a significant element of cost push inflation; where there are often very specific sectoral bottlenecks that can generate inflationary tendencies, and also where we have a real concern about employment generation.

India’s single-minded focus on inflation targets is misguided.

So I would say macroeconomic policy, which includes monetary policy, has to be focused on a range of targets. Yes, you want economic stability and, therefore, some degree of limit on inflation but you also want to generate economic activity and particularly generate employment. So, I don’t believe that the single-minded focus on an inflation target is necessarily something desirable or even achievable in India.
Q: Not even flexible inflation targeting with a band?

Ghosh: When you are in a slump, a band of 2% is not a big deal. You really do need to look at a range of targets—where you are in the business cycle, what kind of monsoon you have had, and so on.

Q: Can the 125 bps cut this year, along with the cut in the statutory liquidity ratio (SLR) and the loan-to-value ratios for housing loans, create a scope for demand-led growth in the country?

Ghosh: Globally, we have seen this tendency, especially in the period after the great recession, that all the burden has been put on monetary policy. I mean except for the fiscal expansion in the US, there’s this general tendency to expect monetary policy to somehow fill the slack. I don’t think it works. And I don’t think it’s going to work in the present case. That doesn’t mean that it will have no impact. Sure, there will be some easing. Corporates have been asking for this, the finance minister has been asking for this, so presumably they feel that there will be some positive impact. However, you cannot get the required expansion today without some kind of demand stimulus and without some kind of productive stimulus that will reduce the supply bottlenecks. Private investment is not geared to reduce supply bottlenecks because most of these are infrastructural, and they have long gestation periods, involve high risk, and so on. So they need public involvement and the demand stimulus doesn’t come necessarily through credit-based expansion, especially when you already have a debt overhang.

A rate cut eases the pinch but doesn’t necessarily make them rush out and spend more.

I think often in India we forget the extent to which we have debt overhang not just among corporates but also among the middle classes. The boom which we had was significantly credit-driven—retail credit went from 4% of total lending to close to 28%. There is significant middle-class involvement in the debt-based purchase of consumer durables, in debt-based real estate purchase, and so on, and now with the real estate market slumping from the last year or so, that has affected the viability of those loans. The general stagnation, or shall I say deceleration of the rate of growth and the stagnation of wage incomes has meant that all these people who took EMIs (equated monthly instalments) for a range of consumer durables are also feeling the pinch. A rate cut eases the pinch but doesn’t necessarily make them rush out and spend more. So I’m not overly optimistic that this rate cut and other monetary measures that are designed to increase demand are going to be enough to pull up economic growth.

Q: Do you see any cause of concern from inflationary pressures in the context of the current monetary policy stance?

Ghosh: At this point, no. The problem globally is deflation, and even though I don’t think we are likely to get deflation in India, except for asset deflation in some areas, I don’t see inflationary pressures being a problem either, so I think there is a plenty of scope to go further in terms of monetary policy. My problem is that I don’t think it’s going have the desired positive impact.

Q: Savings have been declining—particularly household financial savings, possibly due to inflation. Could lower interest rates have a negative impact too?

Ghosh: I would believe that personal savings are relatively inelastic to the interest rate in India simply because experiences with stock market and other financial instruments have been very uneven, and we don’t have proper pension systems so there is little choice. But on the other hand, there is a question of equity; of justice to pensioners and poor people who are saving in, say, post office accounts. So maybe you have to think about a structured system where some types of savings are relatively more protected.

Q: The problem with that, some would argue, is that the relatively higher rates on small savings schemes distort the market and impact transmission.

Ghosh: I think banks are completely unjustified in claiming this. I mean where is the evidence that banks are not getting the savings that they can lend out? They are sitting on them and they are investing them in government securities. I believe, in fact, I have seen studies that actually suggest that bank margins have been rising. So I’m not convinced by this argument at all.

Q: Like you mentioned earlier, representatives of the government have been asking for a rate cut and there have been rumours of a strained relationship. What is your take on the debate over the independence of the RBI, especially in the light of the stress on independence of central banks in developed countries?

Ghosh: I believe an independent central bank is an oxymoron—I don’t believe they exist and I don’t believe they should exist. All the people that tell you that a central bank is independent are basically telling you that it is subservient to financial interests, that is the interest of the financial class, rather than subservient to politics.

I believe an independent central bank is an oxymoron.

Q: What would you say should be the priority for the government in order to step up and be able to help the economy make use of the rate cut?

Ghosh: I think the real drag on the economy today is the pattern of fiscal policy—of public spending. If they want the economy to revive, there needs to be a big push in certain critical areas, which is the opposite of what they are doing. (There needs to be a) big push in rural employment guarantee, creation of an urban employment guarantee, increase of social sector spending for health, education and nutrition, actual implementation of the Food Security Act, and so on. All of this can easily be financed by making the tax administration more efficient. I’m not asking for an increase in taxes. I’m just saying implement your tax laws, properly and seriously.

Q: So what do you make of this push to cut the fiscal deficit?

Ghosh: I think it’s obscene. You don’t do that in the middle of a deceleration. What’s the point, except for some kudos from some international bankers, who are not actually going to come up and help you to increase investment?

First published on Quartz