Monday, March 24, 2008

Inflation and growth concerns in India

Two sets of recently released figures on the economy - the Index of Industrial Production (IIP) and inflation - have set off an interesting debate about the direction of our monetary policy. The RBI has become caught between the never ending debate about making a trade-off between inflation and growth.

Recently released CSO data on the IIP indicates that industrial growth decelerated in January 2008 to 5.3%, compared to 11.6% for January 2007. The biggest hit was taken by the two critical engines of industrial and consequently economic growth - consumer durables and capital goods. While the former fell 3.1% ( a rise of 5.3% in Jan 2007), the later rose a mere 2.1% (16.3% in Jan 2007) for the month of January 2008. However, Fast Moving Consumer Goods (FMCG, consumer non durables), exhibited a 10.1% growth in January, compared to 9.1% last year. Food products, beverages, tobacco etc showed double digit growth. The growth rate of the core infrastructure industries group - crude petroleum, petroelum refinery products, coal, cement, electricity and steel - which has a 26.7% weightage in the overall IIP fell from 4.2%in January, compared to to 8.3% in January 2007.

Wholesale Price Index (WPI) had already begun to breach the self-imposed year-on-year 5% tolerance level in the third week of February and continues to rise. WPI based inflation rate breached the critical 5% mark to close at 5.11% for the week eneded March 1, 2008, the highest in over nine months. It further rose to 5.92% when the latest figures were relased for the week ended March 8, 2008, to reach teh highest figuresince May 7, 2007. The prices for cereals increased 6.28%, for milk 9.71%, vegetables 9.79%, dairy products 9.31%, cement 5.13%, iron and steel 20.87%, and edible oils 17.52%.

There are many reasons to doubt that the drop in capital goods is not part of any long term trend. For a start, statistically 2006-07 was an year of extraordinary industrial growth, with the final quarter growth being 12.5%. Sustaining this was not realistic and maybe not even desirable, given the strains it would place on an already stretched out economy. Investments in the main consumers of capital goods like infrastructure have been growing and shows no signs of slackening. The order books of the main capital goods manufacturers remain buoyant and their sales numbers have shown robust growth. In fact, the key listed capital goods companies grew by about 33 per cent in the last quarter of 2007, in comparison to the same period last year.

The already committed investments in these sectors may be enough to sustain the present capital goods growth trends in the near future. The projected expenditures in these non tradeable services like ports, airports, highways, power, urban infrastructure, telecommunications etc is massive, are by themselves capable of sustaining very high growth rates. The Government's own flagship programs like the Golden Quadrilateral and other National Highway projects, PMGSY, JNNURM, and the programs to promote PPP in core infrastructure, should provide more than adequate demand side stimulus to sustain high rates of growth for sectors like capital goods. The demand for both residential and commercial real estate is both massive and ever growing, and has not shown any signs of slackening. The critical inputs to infrastructure sector like steel and cement, after a blip in January, exhibited robust growth in February.

The construction sector, which encompasses all these infrastructure investments, exhibited one of the lowest sectoral ICORs in the Tenth Plan period at a very low 1.2. It has also been shown that construction sector generates one of the highest employment rates for every rupee investment. All this will ensure that the economic multiplier will be significant from these committed and projected investments. So any talk of a major slowdown may be not based on any logical foundations.

The recent budget cut CENVAT on all goods from 16% to 14%, excise duties on automobiles from 16% to 12%, excise duties on drugs and diagnostic equipments, and some packaged food items from 16% to 8%. These rates were cut with the objective of lowering prices and thereby spurring consumption and boosting industrial and business activity. The consumer durables sector, especially two-wheelers and automobiles, is expected to be one of the largest beneficiaries of this. The Sixth Pay Commission is expected to put nearly Rs 350 bn in the hands of consumers, thereby providing a major filip to manufacturing demand. These are all strong stimulus measures that are expected to keep aggregate demand high, and thereby keep the corporate investment climate healthy.

The Government have responded to the rising food and commodity prices by piecemeal and stop-gap measures like price controls, freeing imports, banning exports (on edible oils), lowering customs duties (on rice and edible oils), imposing export duties (on steel), and prohibiting futures trading (on food grains). These efforts are based on the wishful but futile assumption that it is possible to insulate the Indian economy from the global trend of rising food and commodity prices. This attempt at importing deflation by freeing up the external sector has severe limitations, given the small quantities involved in such trade and the high prices prevalent in the global markets.

The rising global commodity prices, both food and non-food, has pushed up import prices. Addressing this inflation with monetary policy levers may not only not yield results, but may backfire badly, especially at a time when growth itself is slowing down. That the inflation is not driven by demand side pressures is also clear from the fact that growth in money with the public has declined form a very permissible 17% to an even less 14% in Febraury, 2008. The RBI figures show that money supply which has been growing at 22.2% annually, is slowing down to an estimated 21.2%. It is clear that while the demand side is robust, the supply side appears constrained. The rise in inflation is therefore more due to cost push factors than demand pull ones.

The primary objective in a cost push inflation scenario is to ease supply side bottlenecks. The major domestic supply side bottle necks that have been driving prices up include stagnating agricultural production, declining private capital investments in manufacturing, and over-stretched infrastructure, especially power and transport logistics.

The domestic supply side factors that are driving inflation need to addressed through some immediate policy interventions. Infrastructure bottlenecks are an immediate priority that will continue to strangle any economic growth. It is impossible for India to grow at double digit growth rates, by maintaining low inflation, without massive investments in its creaking infrastructure. Agriculture investments, both physical and those aimed at improving productivity, have been declining and this is manifested in the stagnating production, thereby forcing imports. This needs to be addressed immediately on the highest priority, especially given the large share of population dependent on agriculture.

The external sector has also been a significant determinant on price increases. Since 2004, import prices of oil have soared from $34 to $110, palm oil from $471 to $1177, and Thailand rice from $225 per tonne to $510 per tonne. Our import basket has taken an enormous hit, and naturally inflationary pressures have been building up. Commodity prices worldwide - food grains, cash crops, energy and metals - have been growing at an alarming rate. Over the six years to February 2008, the Goldman Sachs broad commodity index jumped by 288 per cent, the energy price index by 358 per cent, the non-energy index by 178 per cent, the industrial metals index by 263 per cent and the agricultural index by 220 per cent.

The external factors are beyond our or anybody's control, and cannot be helped beyond a certain extent. The stronger rupee will help in ensuring cheaper imports and controlling inflationary pressures. The major hope will be that the US recession and resultant drop in consumption will set in motion a chain of events that will bring down global aggregate demand. The reduced US demand will immediately translate into a lower demand for manufacture imports from East Asia and China, and hence demand for many primary commodities and metals.

All this will also reduce the demand for oil and other energy supplies. Economic growth in the merging economies too will drop, though not sharply, thereby further reducing domestic demand in these markets. All this is likely to result in lower commodity prices, which will benefit large domestic market and commodity import dependent economies like India and China.

There have been calls from many quarters to tighten monetary policy in the light of the rising inflation. This may be a wrong prescription for many reasons. Any monetary tightening now will only generate expectations that would force both inflation up and push medium term growth down. Interest rates are critical for Indian industry, especially the massive small scale and unorganised sector, who depend solely on bank debt to finance a major share of even their working capital requirements.

What should the Government do at such times? Such times are a strong reminder of the continuing need to maintain a robust and effective Public Distribution System (PDS), which would help insulate atleast the poorest of the poor from global economic volatility. It is also a reiteration of the importance of food security, and the need to make investments in agriculture with the objective of increasing productivity and thereby expanding production. There is very little Governments can do to control the rising commodity and energy prices, apart from cosmetic exercises that play to the galleries, but will achieve precious little. Aggressive promotion of investments in infrastructure will be important for easing the constraints faced in a sector vital for promotion of overall economic growth.

These times also highlight the immense complexity involved in aggressively intenventionist market controlling approaches like price controls and duty hikes. Therefore, in such circumstances, if the Government decides to assist a category of consumers with some subsidy, it is more appropriate that such subsidies be transferred as direct cash transfers than by meddling with the price mechanism. Such measures are better able to co-ordinate with the market and deliver the full bang for the buck. Besides, it will also prevent market distortions that have consequences that often go much beyond the duration of the crisis itself.

What should the RBI do to ward off inflationary pressures? It appears that the RBI's dilemma can be resolved if not by easing the monetary policy, but atleast by holding on to it, so as to address growth concerns. Any tightening of monetary policy would have serious implications at a time when the investment climate is not at the pink of health. Further, in a cost push inflation scenario, any monetary tightening will be ineffective.

It also a timely reminder about the need to keep a low interest rate cushion when the economy is doing well, so that it gives the Government a sufficient enough interest rate buffer that it can exercise and increase rates when inflation rears its head. In fact, we should have lowered the interest rates late last December itself, in anticipation of such a reality, given the storm clouds that were then gathering around the US economy.

For the foreseeable future ahead, Indian economy will have inflationary pressures stoked up due to factors that are cost-push than demand-pull. Inflation is more likely to arise out of the economy's inability to provide the critical inputs necessary to sustain the fast pace of growth. In such circumstances, monetary policy will be more critical in lowering the cost of capital and encouraging growth, and will have only a minimal role in controlling inflation.

In the final analysis, a 7-7.5% GDP growth rate is by any yardstick a very good deal, especially at a time of such tumult in the global economy. Given the fact that the robust 9% plus growth of the past few years, was taking its toll on an over-stretched economy and supply side constraints were becoming increasingly evident, a relative cooling off should even be welcomed.

Given all our supply side constraints and infrastructure bottlenecks, sustaining a 9% growth without stoking off inflation was an impossibility. A slowdown in growth to 7-7.5% should suit us, in so far as it would help prevent over-heating and consequent build up of inflationary pressures, all of which have the potential of squeezing medium-term growth itself.


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