The RBI's scholarly support will help the finance minister achieve his monetary objectives

For the last five years, India has faced what amounts to a virtual investment famine. This has had a disastrous impact on the growth rate of industry and the expansion of the manufacturing sector which remains India's best long term bet for providing employment.

The government has tried everything, from tax cuts to some relatively minor and politically uncontroversial reforms. Nothing has helped. Industry continues in the doldrums.

A large part of the blame for this state of affairs has attached to the high interest rates. In particular, the RBI has been singled out for some very strong criticism that in its obsession with inflation and the health of the public sector banks, it has neglected to lower interest rates as rapidly as it should have.

The persistent heckling -- not to mention a genuine desire to put the shoulder to the wheel -- seems to finally have had some effect. In its latest Report on Currency and Finance, the RBI has suggested that the time may have come to respond to the criticism.

Accordingly, the Report says that given the real possibility that the current low rate of inflation will continue for some time, and given that Indians find a 5 per cent inflation rate tolerable, a higher inflation and lower real interest rates may actually boost growth.

The argument given for the change in the priorities of objectives are, of course, the persistence of lower inflation and slow growth in India. The recession in countries such as US and Japan and the reaction of their central banks that have sharply cut interest rates the growing faith in the non-neutrality of money and the aggressive cuts in the Fed rate, have also created an awareness of the need to cut rates.

Whether or not this is a correct assessment remains to be seen. But when the RBI makes a case for a cut in interest rates just a few weeks before the Budget, one can only wonder if Bimal Jalan is doing Yashwant Sinha a favour. In the face of the criticism that Sinha will face if he cuts interest rates on small savings, the RBI's rather scholarly and academic support will certainly help.

Though the main objective of the finance minister is to reduce the interest burden of the government, the effect of the rate cut will be a decline in the spectrum of interest rates. This has to be viewed in the context of the fact that people are already lamenting the fact that few assets earn attractive returns.

As a result, Mr Sinha does not have the support for rate cuts from both business and households the way Greenspan does because, unlike in the US where they are net borrowers, households in India are net savers.

And they hold nearly half their savings in financial assets. The political economy implications of an interest rate cut are therefore not very pleasant for the FM -- it becomes a case against the 'common man' and in favour of business.

In other words, Mr Sinha needs all the support he can get to cut interest rates. The RBI makes it case in the report on Currency and Finance released last week. The case rests on three main arguments.

One, that the long run real interest rates should be close to the expected long run growth rate. But in the post 1995 period while the real growth rate has averaged 6.6 per cent the real interest rate has been higher, both ex-poste at 8.7 per cent and ex-ante at 7.5 per cent. There is thus a case to reduce it.

Two, that the impact of increasing the availability of credit with banks is very small, and it is mainly the interest rate channel that is the main mechanism of monetary transmission. Though credit increase has a positive output response, this response takes place mainly through the lending rate.

Evidence indicates that the output response operating through the interest rate channel is stronger and more persistent than that through the credit channel. It is suggested that a 100 basis point reduction in interest rates raises aggregate demand by almost 25 basis points in the short run and up to 50 basis points over time.

This is not surprising because until the 1990s credit control was the main monetary instrument. As some studies have found interest rates emerge as a significant factor explaining the variation in real activity in the 1990s as compared with a negligible impact in the 1980s.

Third, the RBI has pre-empted criticism regarding the effect of monetary expansion through lower interest rates on inflation by arguing that inflation is below the threshold level.

Significantly, it points to the literature that shows that very low levels of inflation are harmful to growth. Inflation at some low levels has positive effects on growth by 'greasing the wheels' of the economy and allowing real wages to adjust.

Thus, it says that at low levels of inflation the growth objective of monetary policy can take precedence over the price stability objective. Or, at least until inflation reaches a threshold level, the level beyond which it has negative effects on growth.

The RBI has also argued that in a low inflation environment, a further reduction in the inflation rate in India by 1 percentage point would reduce output by 2 percentage points from its potential level.

Since the current level of inflation is below the threshold level, this implies that a higher rate of inflation will not only be within tolerable limits but that it will also contribute to growth.

Will it? The answer depends on the mother of all problems, the fiscal deficit. As these contribute to foreign perception of an economy - especially after Argentina -- fiscal authorities will be chary of running high deficits or monetising them. This could lead to a reduction in the traditional conflict between fiscal and monetary authorities. The role of the RBI in controlling inflation could well get reduced.

The role of monetary policy gets redefined in the sense that inflation control need not be its over-riding objective as the government is equally concerned with it. Even though this has not become institutionalised yet, it is probably now somewhat easier for the RBI to give precedence to the objective of growth today than it was earlier.