Monetary Policy and the Non-Performing-Assets...

The problem of Non-Performing-Assets (NPAs) or bad loans in the INDIAn economy is same as the faced by most of the countries after booms, during booms demand is high which leads to more investment, but when demand goes down due to inflation and tightening and unemployment goes up that reduces the gap between nominal and real prices of assets i.e. inflation adjusted prices, when demand is brought down to the supply by increasing interest rates to keep prices stable. When nominal prices are above the real prices of assets it means demand is higher than supply and the equilibrium is brought by equalizing the both prices by tightening the money-supply and when supply is greater than demand the central bank again tries to equalize the both prices and bring stability by decreasing money-supply and increasing the interest rate. To store equilibrium it is important to bring demand and supply equality with full-employment and that is restored when the difference between nominal and real prices, i.e. inflation, is zero. However, supply-side problems and full employment are often responsible for overheating for which a lower borrowing cost might also help with a time-lag, the RBI might also try to increase supply by cheap credit. Therefore, to keep inflation and inflation expectations low and to bring equilibrium in demand and supply the RBI had increased the interest rates when inflation increased double digits after the Financial-Crisis 2008 reinforcements which made investment costly and turned many loans bad due to low income flows and demand in the economy. But, it is natural for some debt to go bad because any business is risky due to a low demand cycle, busts or slowdown; the INDIAn economy is still recovering from a slowdown, nonetheless its growth is fastest among the major economies, but bad loans from the past boom is still endangering a full-fledged recovery and robust job creation to provide 1.7 million jobs to its workforce every year, a target that has been consistently undershot. NPAs are a blot on the bank finance which must be removed by effective measures undertaken by the policy-makers, especially the RBI which is important for the regulation of credit in the economy, the government has also assured recapitalization of banks through the budgets, but it is insufficient given the magnitude of the problem which hovers over Rs 10 trillion. This money is a big drag on the credit creation power of the banks, especially the public-sector, through which the RBI regulates demand/supply, prices and growth in the economy and it is expected that it will soon come up a credible plan to curb bad loans. Higher interest rate itself could be a reason for bad loans, lower borrowing cost could bring some of the investments back, and it is big relief. Bailing-out or monetising the debt has been a practice that is frequently used to correct commercial banks balance sheets. When subprime loans gone bad during 2008 recession, the US government bailed out big banks and the Fed conducted the quantitative easing program to improve banks’ balance sheets, it cut down on reserve requirements and repo-rates, it administered a huge asset purchase program which lowered both long-run and short run interest rates which increased the capacity of banks to provide credit, the government too reduced its finances which left more money for the private sector. INDIA too should come-up with ideas to correct the problem of bad loans and low demand and growth, for which the US sub-Prime Crisis might provide a right framework........

Jobs' Problem is Fundamental...

In the backdrop of the 2008 financial crisis or the Great Recession the economists came to the conclusion that the economy must be given the stimuli of the monetary and fiscal policy to lower unemployment which reached double digits in the aftermath of the crisis with falling inflation which also made the Fed target higher prices while embarking on the quantitative easing program. The discussion centered around to lower unemployment and creating job oppourtunities in order to avert falling demand and prices for which money-supply was kept high to flow in to businesses with excess capacity which took time to increase because of low demand or higher unemployment, it was mainly about creating jobs to lower unemployment and increase inflation through wages instead of price-stability to increase demand, consumption and investment spending, it also increased depreciation and exports and lowered trade-deficit for some time. But, with excess supply of labour wages remained low and showed less pressure build up to increase demand, inflation and growth for a long-time; however the focus was on creating jobs and lower unemployment or achieve full-employment to arrest or increase falling growth which has been the primary objective besides the secondary objectives of price stability and full-employment of the economic policies. This might also help the policy making in INDIA to align policies to achieve its objective of providing productive jobs to its workforce, productive because it mostly uses unskilled labour which has kept wages and incomes depressed even though the workforce is fully employed.  The higher proportion of unskilled labour has kept productivity and wages low when higher inflation in the past had also kept real wages low that resulted in low demand and growth in the preceding years. The NREGA the flagship program of the previous UPA government even though increased employment, but failed to increase productive assets and human capital which led to higher inflation and wage demand and diverted resources away the market. The former government increased intervention in the market to increase jobs that are not so productive and may increase wage cost and lose competitiveness, however it tried to increase competitiveness by cutting real wages with inflation, as done to increase depreciation and exports. In 1991 our former PM in his stint as the Finance Minister tried depreciation to revive the economy. Even when free market and liberalisation is widely hailed the NREGA program is a direct intervention of the government to create jobs oppourtunites without increasing productivity, because when employment is increased it creates demand in the economy, but if production is not increased it would result in inflation and low real wages, moreover it would result in crowding out of private investment, the private sector would become costly and lose competitiveness. Therefore, NREGA is only a short term jugaad to provide temporary jobs without skills which actually should be provided by the market which is against the market principle, however if the government had spent on increasing productivity through investment in education and skills development according to the market it would have increased production and lower inflation, moreover productivity had also increased wages or real wages also because of lower inflation. The NREGA worked well for the politicians, but has made people dependent on the state for employment without their skill development, it is only a short-run fix for the problem of unemployment, unskilled labour-force and jobs which is also a drag on the Public-Finance that also needs re-orientation to create productive assets and human capital that would also help increase tax-base in the economy...   

Competitiveness...

The Competitiveness of an economy and its industries is increased either by cutting costs or by increasing productivity, higher production might help reap the economies of scale by reducing prices and increase demand and sell more and also earn interest income. There are three main things that determine the competitiveness of the domestic economy and the exports and they are the wages, the interest rate and the exchange rate, wages and interest rate are the two main input costs, besides other inputs, that determine the cost and price for the people and thereby competitiveness and demand in the face of peers or competitors to increase market share, domestic and external. Notwithstanding, if we go further we find that it is the real wages, the real interest rate and the real exchange rate which are important because of inflation. A lower inflation would increase them and a higher inflation would lower them, we know that higher inflation would lower demand by reducing the real wages, real interest rate and real exchange rate and a lower inflation would increase demand and growth because consumption and investment spending and exports would increase. However, the supply side weaknesses are often responsible for high inflation, apart from full-employment because supply could not be increased, but innovation, skills and technology may help increase productivity or production at lower cost. According to Solow, any technology is positive if it cut costs and/or lower prices and increase production.  In a nut shell, lower prices increase competitiveness, demand and the economic-growth rate because it also reduces nominal interest rate and demand for higher wages, a lower nominal interest rate would also reduce borrowing cost and increase supply and lower prices. Nonetheless, demand for foreign exchange might become a problem if the economy imports more than what it produces to consume, which might retard domestic investment due to increased foreign competition. And, when foreign competition comes in it makes the real effective wage rate, the real effective interest rate and the real effective exchange rate important from the point of view of competition i.e. the ratio of nominal wages/interest rate/exchange rate of the domestic country and the foreign country divided by the ratio of prices or inflation in the domestic economy and the external economy, when the real effective wages increase and real effective interest rate and real effective exchange rate in the domestic economy go up because of lower inflation and nominal rates at home it increases the competitiveness of the domestic economy vis-a-vis the external economy which increases demand and growth. The higher real effective wages would increase demand for both, the domestic demand and imports and exports would also increase because of higher exchange rate and a lower nominal interest rate could also increase investment demand, all because of lower inflation or prices. Lower prices because of the lower borrowing cost could do much to increase competitiveness, demand and growth, it would also restrict wage demand, and people would consume more and save more and the economy would investment more. Both, Keynes and Milton Friedman have seen lower interest rate as the optimal monetary-policy, but the former had assumed sticky prices and positive nominal interest rate and the latter has viewed prices as flexible and, possibly, zero real interest rate as the right monetary-policy. Keynes assumption about prices as sticky is not evident in the real world as prices or inflation have gone down as a result of expansion in money-supply and lower interest rate, close to Friedman’s optimal monetary-policy, nonetheless he (Keynes) also viewed nominal interest rate to be zero or euthanasia of the renter of capital as a probable outcome of printing money in the long-run.

*In International-Trade paradigm increase in the exchange rate is depreciation and decrease is appreciation.

Exports Might Help Increase Jobs and Growth...

Even though INDIA has so far relied on the domestic demand for growth, external demand could also be pursued for a higher growth-rate, when some of the sectors of economy have been overburdened for employment, like agriculture, when it has depressed the wage rates and incomes by the oversupply of labor, however there are fewer value addition jobs that contribute to productivity and real-GDP in manufacturing and services due to low skills base, moreover construction has also attracted unskilled labor that is abundant which is also responsible for lower wages, demand and growth. INDIA has a large pool of unskilled labour which might be diverted from agriculture and construction to manufacturing and services and export oriented businesses by imparting skills according to the industry demand. Lower paying sectors and industries are responsible for lower wages coupled with lack of skills and low demand and growth. INDIA so far has resorted to domestic demand also due to low manufacturing and exports, but now it must look-up for exports which has the potential to provide jobs and increase employment opportunities. As we know, INDIA has a much larger young-working age population, but the economy is lagging by creating less jobs and demand. INDIA needs to create 1.7 million jobs every year for 10 years to absorb the labour-force that is increasing 10% per 10 year, but slow pace of investment might obstruct the economy’s long-run target to provide full-employment.

Poor people's’ marginal propensity to consume is higher; therefore the accelerator is bigger than the investment multiplier, because all wages are consumed because of the subsistence wage theory. Capitalists bid the wages at the minimum or subsistence wages, moreover inflation also lowers real wages by inflation, but it also reduces the value of investment, profits and savings, which counters the argument that inflation reduces the value of debt; inverse of the debt-deflation dynamics by Fisher, inflation would affect everybody in terms of the purchasing power, investors should invest when inflation is low and increase supply when and where prices are high, lower prices also increase real wages and contain demand for wages. However, depreciation and higher expected inflation may be responsible for higher nominal exchange rate and exports. But, lower real wages at home might reduce domestic demand for demand of exports. The inflation in INDIA has gone down in the recent past which has also made the rupee stronger which is likely to reduce the current account deficit and the RBI’s neutral monetary policy stance has also yielded in terms of stronger exchange rate.  However, lower inflation might also make the economy competitive and increase exports.

INDIA Still Needs More Investment...

Now, that our RBI Guv has floated that we have (possibly) reached the bottom of rate cuts even when the supply-side is weak in INDIA and it needs investment, which has been covered by the foreign investment, greater space for the foreign direct investment to increase employment and foster price-stability when domestic investors are slow to spot opportunity because of higher borrowing cost. However, INDIA’s foreign external debt has shot up like never before in case of lower interest rate abroad after 2008, but it is still questionable, that when investment has been controlled by the RBI by higher rate of interest, how foreign direct investment might help since it would increase demand and inflation too… It shows that INDIA needs investment despite of inflation because it has been plagued by inefficient supply-chains due to low level of investment, it is true that it has a huge population and demand, but it is still suffering from inadequate investment, lower productivity and supply, the RBI chose to control demand, but it is an irony that supply too needs a push by more investment. A policy rate of 6.25% when it is 2% in the trading partners’ economy would make INDIA uncompetitive, especially the commercial banks in the terms of credit-cost and businesses too. Nonetheless, we need to view the RBI’s Monetary Policy from the perspective of the Taylor-Rule, a landmark for the Monetary-Policy, which might further provide a framework to conduct money-supply and interest rate management. According to the rule, the natural rate of interest, that is important for neither an inflationary nor deflationary price spiral, i.e. price-stability, should be targeted for an effective monetary policy and it is almost constant. In the context of the rule we see that real interest rate has been higher than the target 2%, set by the apex bank, in case of the key rates and even more in case of the money or market or nominal rates, we have a real rate of 2.75% if we include the repo rate and that is higher than our target, therefore there is a space for more rate cuts of more than 50 basis points and even more in the market rates, the Indian banks saddled with bad loans need more accommodative action which a rate cut might provide. INDIA has a higher real rate of interest, but is yet to achieve the natural real rate of interest which might be lowered in case of inflation lower than our target. It would improve sentiment or the central bank might conduct open market operation to pass on the previous rate cuts with adequate liquidity. INDIA has lost half of a percentage of the real GDP in the aftermath of demonetization which might be gained by a 25 basis points cut in the policy rates, the Taylor rule says that we have to cut repo rate by 0.50% if the growth rate falls 1%. In other words to achieve 8% the RBI might cut by 50 basis points. INDIA has a higher real interest rate compared to other major economies which is also likely to depress exports.      

The Inflation Assumption....

It is often said that the assumptions under which the economic-theories have been said to be true are different from the real-World situation which restricts the ability to forecast the future and devise appropriate measures to achieve price-stability and full-employment and full-growth. However, full employment constrains output and is responsible for the former and higher interest rate, after which prices start increasing because production could not be increased in the short-run and labour demand higher wages because of low supply of labour and also due to inflation and lower real wages, scarcity increases the price of labour which gets transmitted in other cost and prices and the central bank tightens money-supply and increases the interest rate. At one place inflation goes up and at the other, the central-bank would also increase the prices by increasing the borrowing cost which further restricts supply and increase the prices. It is a common assumption or belief that after full-employment more money-supply from either monetary or fiscal policy would only increase prices without any effect on the real economy and employment, full-employment, higher money-supply and lower interest rate would increase overheating and the economy would lose competitiveness which the central bank would try to control by increasing interest rates and tightening, which again lowers competitiveness by increasing the borrowing cost which might not be the best way to increase supply, but they try to control demand by increasing unemployment which also decreases supply which is likely to increase the prices, instead of containing them. Nonetheless, depreciation or external devaluation might help increase exports, but, at a time when labour is scarce increase in demand would further lead to higher wages and costs which would negatively affect the competitiveness of the economy and the appropriate lever would be to control demand by increasing the exchange rate, however imports would help achieve price-stability after full-employment. Notwithstanding, there is an alternative view proposed by the Neo-Classicals or Freshwater economists that higher money supply might also decrease interest rate and increase supply (and probably lower prices) and Keynes view about capital in the long-run also point to lower long-run interest rate opposite of higher long-run rates in the real-World, long-run rates are generally higher than the short-run rates because of inflation and inflation expectations. People generally assume inflation in the long-run because the economists had assumed higher population growth rate which would drive-up prices, but on the contrary the real time shows that population growth rate has gone down and supply has increased with the lower borrowing cost, the natural effective real rate of interest has come down from its long-run trajectory…