6. Economics Notes 10

Elaborate Notes

Qualitative Tools of Monetary Policy

• Credit Authorisation Scheme (CAS):

  • Introduced by the Reserve Bank of India (RBI) in 1965, the CAS was a tool of selective credit control characteristic of the pre-liberalisation, ‘License Raj’ era. This period was marked by a planned economy where the government and RBI sought to direct economic resources towards priority sectors.
  • Historical Context: The scheme mandated that commercial banks obtain prior authorisation from the RBI before sanctioning any new credit limit of ₹1 crore or more to a single borrower. This threshold was later revised upwards.
  • Objective: The primary goal was to align bank credit with the objectives of the Five-Year Plans. The RBI aimed to prevent the use of scarce bank credit for non-priority or speculative purposes and ensure that large borrowers did not monopolise credit resources. Committees like the Tandon Committee (1975) and the Chore Committee (1979) were established to recommend norms for inventory and credit, further strengthening the RBI’s micro-management of credit allocation.
  • Discontinuation: The scheme was phased out and ultimately discontinued in 1989, replaced by the Credit Monitoring Arrangement (CMA). This shift reflected the broader move towards economic liberalisation, where direct controls were replaced by prudential norms and market-based mechanisms. However, the RBI continues to monitor large credit exposures as part of its supervisory function.

• Rationing of Credit:

  • This is a method used by the central bank to control and regulate the purpose for which credit is granted by commercial banks. It involves two key dimensions:
    1. Variable Portfolio Ceilings: The RBI can fix a maximum limit on the loans and advances that can be made by commercial banks to specific sectors or industries.
    2. Variable Capital-Asset Ratio: The RBI can mandate a specific ratio of capital to assets that commercial banks must maintain, indirectly controlling their lending capacity.
  • Discounting and Re-discounting of Bills: This is a crucial mechanism within credit rationing. A Bill of Exchange is a promise of future payment.
    • Example: An exporter ships goods worth ₹1 lakh to an importer, with payment due in 90 days. The exporter possesses a bill of exchange. If the exporter needs funds immediately, they can take this bill to a commercial bank (e.g., SBI). The bank will ‘discount’ the bill, paying the exporter a sum less than the face value (e.g., ₹90,000, with ₹10,000 as the discount/fee).
    • The commercial bank can then take this bill to the RBI for ‘re-discounting’ to acquire liquidity. By refusing to re-discount bills from certain sectors or by setting a high re-discount rate, the RBI can discourage banks from lending to those sectors, thereby rationing credit. During inflationary periods, the RBI can impose upper limits on re-discounting to curb liquidity.

• Moral Suasion:

  • This refers to the use of persuasion, advice, and informal guidance by the central bank to commercial banks to achieve monetary policy objectives. It is a psychological tool rather than a statutory one.
  • Methodology: It is exercised through speeches by the RBI Governor, official letters, circulars, and periodic meetings with the heads of commercial banks. For instance, the RBI Governor might urge banks to pass on the benefits of a repo rate cut to borrowers more quickly or to increase lending to Micro, Small, and Medium Enterprises (MSMEs).
  • Effectiveness: Its success depends on the prestige of the central bank and the cooperative relationship it has with the banking system. In India, given the RBI’s statutory authority, its “suggestions” are typically taken very seriously by banks. Scholars often refer to this practice globally as “jawboning”.

• Direct Action:

  • This is the most stringent qualitative tool, representing a punitive measure taken by the RBI against commercial banks that fail to comply with its directives.
  • Statutory Backing: The authority for such action is derived primarily from the Banking Regulation Act, 1949.
  • Forms of Action: Direct action can range from the RBI refusing to re-discount bills for a non-compliant bank, charging penal rates of interest on loans given to such banks, to more severe measures like imposing monetary penalties, restricting the bank’s operations, or in extreme cases, recommending the cancellation of its banking license or superseding its Board of Directors (as seen in the case of Yes Bank in 2020 and PMC Bank in 2019).

Challenges of Monetary Policy in the Long Term

• Monetary policy, primarily through interest rate adjustments, is highly effective in managing short-term aggregate demand and controlling inflation. However, its ability to foster long-term, sustainable economic growth is limited. It can create a conducive environment for growth but cannot be the sole driver.
• Long-term growth is fundamentally a function of a country’s productive capacity, which depends on structural factors. These are primarily addressed by fiscal policy and other government reforms:
  • Fiscal Policy: Efficient tax policies (e.g., Goods and Services Tax), rationalization of subsidies, and targeted capital expenditure by the government (e.g., National Infrastructure Pipeline) are essential for creating physical and social infrastructure.
  • Structural Reforms: These include reforms in factors of production. For instance, labour law reforms (such as the consolidation of central labour laws into four codes) aim to improve flexibility and formalisation. Land reforms and reforms in the agriculture sector are also critical.
  • Business Environment: Improving the ‘ease of doing business’ through regulatory simplification, transparent contract enforcement, and stable policies is crucial to attract private investment.
  • Macroeconomic Stability: Maintaining control over the twin deficits—Fiscal Deficit and Current Account Deficit (CAD)—is a prerequisite for long-term stability and investor confidence.
  • Monetary Policy Transmission: A key challenge in India has been the inefficient transmission of policy rate changes to the actual lending and deposit rates of banks. The RBI’s move from the Base Rate system to the Marginal Cost of Funds-based Lending Rate (MCLR) in 2016, and subsequently to the External Benchmark Linked Rate (EBLR) in 2019, were attempts to rectify this lag.
• Conclusion: Sustainable long-term growth necessitates a synergistic ‘policy mix’ involving close coordination between the RBI’s monetary policy and the government’s fiscal and structural policies.

Investment Models and Planning

What is Investment?

• In economics, ‘investment’ refers to the creation of new capital assets. It is synonymous with capital formation, which is the net addition to the existing stock of physical capital (e.g., machinery, equipment, buildings, infrastructure).
• Distinction from Financial Investment: This is fundamentally different from the common usage of the term ‘investment,’ which often refers to the purchase of financial assets like stocks, bonds, or mutual funds. For an economist, such transactions are merely a transfer of ownership of existing claims and do not create new productive capacity for the nation as a whole. The financial asset of one party is offset by the financial liability of another.
• Measurement: In national income accounting, investment is measured as Gross Fixed Capital Formation (GFCF) plus the change in inventories.
  • Gross Investment: The total value of new capital goods produced in a year.
  • Net Investment: Gross Investment minus Depreciation (also known as Consumption of Fixed Capital), which represents the wear and tear of existing capital stock. Net investment indicates the actual addition to the country’s productive capacity.

Circular Flow of Income (Two-Sector Model)

• This is a simplified model illustrating the flow of goods, services, and money between the two main sectors of an economy: Households and Firms.
• Assumptions (Simple Model):
  1. Only two sectors exist: Households and Firms.
  2. The economy is closed (no foreign trade).
  3. There is no government sector (no taxes or government spending).
  4. Households spend their entire income on consumption (no savings).
• The Flow: Households provide factor services (land, labour, capital, entrepreneurship) to firms. In return, firms make factor payments (rent, wages, interest, profit) to households. This income is then used by households to buy goods and services produced by the firms, creating consumption expenditure for firms. This creates a continuous, circular flow.
• Modification with Financial Markets (Banks):
  • When we introduce a financial sector (banks), the model becomes more realistic. Households may not spend their entire income; the part they do not spend is called Savings. This represents a ‘leakage’ from the circular flow.
  • These savings are deposited in banks, which then lend this money to firms for investment in new capital goods. This act of investment is an ‘injection’ into the circular flow.
  • For the economy to be in equilibrium, the total leakages must equal the total injections. In this modified two-sector model, this means Savings (S) = Investment (I).

Investment-led vs. Consumption-led Growth

• Investment-led Growth:

  • This model prioritizes increasing the rate of investment (capital formation) as the primary engine of economic growth. The logic is that higher investment leads to the creation of new productive capacity, which in turn leads to more output, employment, and exports.
  • The Chinese Experience: Post the reforms initiated by Deng Xiaoping in 1978, China aggressively pursued this model. It opened its economy to Foreign Direct Investment (FDI), established Special Economic Zones (SEZs), and leveraged its vast pool of cheap labour. This led to a massive increase in its manufacturing capacity. China’s investment-to-GDP ratio has consistently been over 40%, one of the highest in the world. This strategy powered its rapid GDP growth but also created imbalances, such as over-reliance on exports, suppressed domestic consumption, and mounting debt.
  • **India’s $5TrillionEconomyGoal:\ast \ast TheGovernmentofIndi{a}^{\prime }starget,announcedin2019,tobecomea$5 trillion economy by 2024-25, was predicated on a strategy outlined in the Economic Survey 2018-19. This strategy envisioned creating a “virtuous cycle” kick-started by private investment, which would create jobs, raise incomes, boost consumption, and thereby fuel further investment.

• Consumption-led Growth:

  • This model relies on domestic consumption as the main driver of growth. When households have higher disposable incomes and are confident about the future, their spending on goods and services increases, which drives production and economic activity.
  • The Indian Experience: India’s growth story, particularly in the post-liberalisation era, has been predominantly driven by domestic consumption, which accounts for nearly 60-70% of its GDP. This makes the Indian economy more resilient to global shocks compared to export-oriented economies. However, this growth can be constrained if productive capacity does not expand in tandem, leading to inflation and a higher current account deficit.

Nominal vs. Real GDP

• Nominal GDP: Measures the total value of all final goods and services produced in an economy in a given year, calculated using the current market prices of that year. An increase in nominal GDP can be due to an increase in production (quantity), an increase in prices (inflation), or both. The $5 trillion target is a nominal GDP target.
• Real GDP: Measures the total value of all final goods and services produced in an economy in a given year, calculated using the prices of a fixed base year (constant prices). Real GDP filters out the effect of price changes and thus reflects the actual increase in the volume of production. It is a more accurate measure of economic growth.

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Prelims Pointers

• The Credit Authorisation Scheme (CAS) was a selective credit control tool introduced by the RBI in 1965 and discontinued in 1989.
• Qualitative (or Selective) tools of monetary policy include Moral Suasion, Rationing of Credit, and Direct Action.
• Discounting of a bill is when a commercial bank purchases a bill of exchange at a price lower than its face value.
• Re-discounting is when the central bank (RBI) discounts a bill already discounted by a commercial bank.
• The statutory power for the RBI to take ‘Direct Action’ against banks is derived from the Banking Regulation Act, 1949.
• In economics, ‘Investment’ is defined as the addition to the physical stock of capital, also known as Capital Formation.
• Gross Fixed Capital Formation (GFCF) is a measure of investment in the national accounts.
• Net Investment = Gross Investment - Depreciation.
• In the Circular Flow of Income, savings are a ‘leakage’ and investment is an ‘injection’.
• The equilibrium condition in a simple two-sector economy with a financial market is Savings (S) = Investment (I).
• GDP Equation (Expenditure Method): GDP = C + I + G + (X - M), where C=Consumption, I=Investment, G=Government Spending, X=Exports, M=Imports.
• India’s economic growth model has been primarily consumption-led.
• China’s economic growth model has been primarily investment-led and export-oriented.
• Nominal GDP is calculated at current prices.
• Real GDP is calculated at constant (base year) prices.

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Mains Insights

Coordination between Monetary and Fiscal Policy

• Interdependence: Monetary policy, managed by the RBI, aims for price stability and growth by controlling the money supply and interest rates. Fiscal policy, managed by the government, uses taxation and public expenditure to influence the economy. These two policies are deeply interconnected. An expansionary fiscal policy (high government spending/low taxes) can be inflationary, forcing the RBI to adopt a contractionary monetary policy (raising interest rates), which can crowd out private investment.
• Cause-Effect Relationship: For long-term sustainable growth, both policies must work in tandem. While the RBI can lower interest rates to encourage investment, its efforts will be futile if structural bottlenecks like poor infrastructure, rigid labour laws, or policy uncertainty (fiscal domain) are not addressed. These supply-side constraints can limit the economy’s productive capacity, meaning that a monetary stimulus would only lead to inflation rather than real growth.
• Modern Context: In the context of the Fiscal Responsibility and Budget Management (FRBM) Act and the flexible inflation-targeting framework of the RBI, a formal coordination mechanism is essential. A prudent fiscal stance provides the RBI with more space to conduct an accommodative monetary policy to support growth without stoking inflation.

Debate: Investment-led vs. Consumption-led Growth for India

1. The Case for Shifting to an Investment-led Model:

   • Need for Job Creation: India’s consumption-led growth has often been characterized as ‘jobless growth’, particularly in the manufacturing sector. An investment-led model, focused on building industrial and infrastructural capacity, has a higher potential for creating large-scale blue-collar jobs.
   • Boosting Productive Capacity: To meet the demands of a growing population and to avoid inflationary pressures and a high current account deficit, India needs to significantly expand its productive capacity. This requires a massive push in private and public investment.
   • Virtuous Cycle: As argued in the Economic Survey 2018-19, a strategic push to investment can trigger a virtuous cycle of higher exports, job creation, increased income, which in turn fuels both consumption and savings, leading to further investment.

2. Feasibility and Challenges of an Investment-led Model for India:

   • The Changed Global Context: As scholar and former RBI Governor Raghuram Rajan has argued, India attempting to replicate China’s export-led model in the current era faces significant headwinds. The rise of protectionism, deglobalisation trends, and disruptions to global supply chains make an export-heavy strategy far more challenging than it was for China in the 1990s and 2000s.
   • The Rise of Automation: The nature of manufacturing is changing due to AI and robotics. The low-skilled assembly-line jobs that powered China’s rise are increasingly being automated, reducing the comparative advantage of a large labour force.
   • Domestic Constraints: India faces significant domestic challenges that hinder private investment, including a high cost of capital, complex regulatory environment (despite improvements in ‘Ease of Doing Business’ rankings), land acquisition issues, and inconsistent policies. The problem of ‘twin balance sheet’ stress (overleveraged corporates and banks with high NPAs) has also constrained investment for a long period.
   • Historiographical Viewpoint: Historically, India’s democratic and federal structure makes it difficult to implement the kind of top-down, state-directed investment push that was possible in authoritarian China. Policy implementation is often slower and more contentious.

3. A Balanced Path Forward:

   • Instead of a binary choice, India may need a hybrid model. The focus should be on creating an enabling environment for private investment while simultaneously strengthening the domestic consumption base.
   • This involves a two-pronged strategy:
     • Supply-Side: Implementing structural reforms in factors of production (land, labour, capital) and investing heavily in infrastructure (e.g., National Logistics Policy) to reduce the cost of doing business and enhance competitiveness.
     • Demand-Side: Strengthening the social safety net, investing in health and education (human capital), and ensuring financial inclusion to boost the long-term consumption and earning capacity of the population. This creates a sustainable domestic market that is less vulnerable to external shocks.