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Economy Issues 2021

Economy Issues 2021
source- @kb-team

1. Re-evaluating inflation targeting

Context:

March 31st will mark the end of the term of monetary policy framework agreement between the Centre and the Reserve Bank of India (RBI) on inflation targeting.

The given article evaluates the effectiveness of the monetary policy.

Inflation targeting:

Inflation control is a legitimate objective of economic policy given the correlation between inflation and macro-economic stability.

Inflation targeting is one of the many inflation control policies.

Unlike the money-supply targeting policy of inflation control, inflation targeting method prescribes the use of the interest rate to target inflation. Given that the policy interest rate, is under the direct control of the central bank, this method is believed to be more effective than the monetarist approach.


Details:

Though the inflation rate has remained within the prescribed band of 2% to 6% since 2016 and the RBI has succeeded in anchoring inflationary expectations, the available evidence and observed trends are not conclusive on the efficacy claimed for inflation targeting.


Logical vulnerabilities in the assumed model:

The economic model that underlies inflation targeting revolves around the proposition that inflation reflects “overheating”, or economic activity at a level greater than the “natural” level of output, having been taken there by central banks that have kept interest rates too low, at a level lower than the “natural” rate of interest. This necessitates the need to raise the rate of interest (‘repo’ rate) to control inflation.

Inflation in India entered the prescribed band of 2% to 6% two years before inflation targeting was adopted in 2016-17. In fact, inflation had fallen steadily since 2011-12, halving by 2015-16. This by itself suggests that there is a mechanism driving inflation other than what is imagined in inflation targeting.

The decline in inflation has been mainly led by the relative price of food. The vagaries of the price of food are a major determinant in inflation rate and the adopted model fails to acknowledge this aspect.


Impact of inflation targeting:

Five variables namely growth, private investment, exports, non-performing assets (NPAs) of commercial banks, and employment would be analyzed here.

The economy’s trend rate of growth actually began to decline after 2010-11. This trend was observed despite falling inflation trend. It indicates that the sharply falling inflation could do nothing to revive growth, belying the proposition that low inflation is conducive to growth.

The swing in the real interest rate of over 5 percentage points in 2013-14 was powered further in 2016, when inflation targeting was adopted, and could have contributed to a declining private investment rate. This indicates that the higher interest rates, the toolkit for inflation targeting, may have been harmful for private investment in the economy.

Exports and employment rates have fared poorly since inflation targeting was adopted in 2016.

It has long been recognised that a central bank focusing on inflation may lose control of financial stability. NPAs have grown since 2016, and the cases of IL&FS, PMC Bank, PNB and YES Bank are indicative of the poor management and malfeasance in the financial sector, given the excessive focus of the central bank on inflation targeting.


Conclusion:

Though Inflation control will always be relevant for macroeconomic stability, there is no conclusive evidence that the policy has worked in India as the presumed benefits of low inflation are yet to become evident.

Infact inflation targeting may end up raising interest rates to higher and higher levels which bring out many negative impacts as discussed above, without lowering inflation.


2. Looking beyond privatisation


Context:

The Union government has announced its intent to privatise Public Sector Banks (PSBs) in the recent Budget session.


Details:

The article argues against the proposed move to privatise Public Sector Banks based on the following arguments.


Wrong notion:

The failure of innumerable private banks around the world, challenge the notion that only private banks are efficient. The large volumes of NPAs observed in private corporate entities also challenge the notion of private enterprises being the epitome of efficiency.


Positive role played by public banks:

The nationalisation of 14 private banks in 1969, followed by six more in 1980, transformed the banking sector and ensured the following benefits.

Neglected areas like agriculture, poverty alleviation plans, rural development, health, education, exports, infrastructure, women’s empowerment, small scale and medium industry, and small and micro industries, have witnessed increased credit disbursal rates from the public sector banks.

The nationalization of banks helped in promoting more equitable regional growth. The increased number of bank branches in rural areas has reduced the poor people’s dependence on moneylenders and thus helped move out of the vicious cycle of poverty.

Bank nationalization helped create jobs. They also improved the working conditions of employees in the banking sector, as the state ensured higher wages, security of services, and other fringe benefits.

As an institution, PSBs have been vehicles of the Indian economy’s growth and development. They have also contributed significantly to infrastructural development.


Threat posed by privatization of banks:

Placing the huge network of bank branches and the infrastructure and assets in the hands of private enterprises or corporates may turn out to be detrimental given the risks of monopoly and cartelisation of the crucial financial sector and this could lead to denial of economical banking services to the common man.


Unfair criticism of Public sector banks:

  • It is unfair to blame PSBs alone for the alarming rise of NPAs.
  • Wilful default by large corporate borrowers and subsequent recovery haircuts and write-offs, have put a big dent on the balance sheets of PSBs.
  • The lack of strong recovery laws and lack of criminal action against wilful defaulters is a major lacuna in the system.


Recommendations:

Stringent measures are required to recover large corporate stressed assets.

There is an urgent need to bring in a suitable statutory framework to consider wilful defaults on bank loans a “criminal offence”.

There should be a system to examine top executives of PSBs across the country which will help in improving accountability among the top executives of the bank.

Conclusion:

Privatisation of PSBs is not a definitive panacea for the problems of the banking sector in India.

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