The current round of inflation and the responses of the government appear to be an action replay, in slow motion, of the policy disaster that led up to the industrial slowdown of the mid-’90s. That was India’s first encounter with the difficulties of having an open capital account, a pegged exchange rate and an attempt at controlling domestic inflation. The RBI, which often likes to repeat how well its macroeconomic stabilisation policies have served India, messed up badly. When its dollar purchases led to high money supply growth and high inflation, the RBI sterilised its foreign exchange intervention through a series of hikes in the Cash Reserve Ratio (CRR) and interest rates. Credit growth was squeezed till the growth of non-food credit fell to less than 15 per cent. Not surprisingly, industrial production, which had been growing at double digits, fell sharply. So much so that in January 1997, the Index of Industrial Production witnessed a mere 1.5 per cent annual growth. Following the excessive credit tightening, Indian industry lost its growth momentum and witnessed single-digit growth for a decade.

Is the current monetary policy likely to apply brakes to India’s growth story? In recent months, a story similar to that of the mid-’90s appears to be taking shape. When RBI dollar purchases resulted in high reserve money growth in the mid-’90s, it was unable to sterilise them through open-market operations since the government bond market was undeveloped. In recent years, the RBI has found it easier to sterilise its forex intervention due to a better government bond market. However, as in many other countries that undertake the path of sterilised intervention, when the policy is followed for a long period of time, it becomes increasingly difficult to make the banking system hold more and more government securities. Instruments like the CRR, the share of deposits that banks have to hold with the RBI, are sometimes used and interest rates are raised. The hikes in the CRR that have been undertaken in recent months have, as desired, resulted in a reduction in credit growth. The question is, what might follow next, and is the government sure it wants to make this policy choice?

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