Some sections of India Inc have been demanding a cut in indirect tax rates by one or two percentage points in the Budget to perk up a slowing economy but Laura Papi, International Monetary Fund (IMF) head for Asia and Pacific says the current momentum in the Indian economy does not warrant such cuts. She tells Dilasha Seth that inflation is still a cause for worry — the fall being due to a high base effect and the Reserve Bank of India should not hasten to cut rates unless the fall in the rate of price rise is sustained for a longer duration. Edited excerpts:
The International Monetary Fund (IMF) has suggested that India should go for indirect tax cuts and boost the capital goods industry rather than giving subsidies if output falls substantially. If we assume that India is unlikely to witness a contraction of gross domestic product (GDP) and that there will be some growth, however marginal, do you expect India to go for the prescription that you suggested? By cutting indirect taxes do you mean taxes in general or are you referring to sector-specific taxes? Can India afford such cuts, given the strain on its finances?
If India’s growth continues on its current trend, there is no scope for tax cuts. However, if a crisis in the global economy affects India strongly, as it did in 2008-09, and confidence is severely affected, then some fiscal stimulus may be warranted. Given high interest rates and the government’s already large borrowing requirement, however, any stimulus should be small and focused. As for the composition, sector-specific tax cuts distort economic activity and should be avoided. Capital spending is a priority for India in any case; removing roadblocks to facilitate infrastructure is important under any circumstances.
IMF has suggested that India should be cautious on monetary and fiscal easing because of high levels of inflation and public debt. But inflation has started easing lately, and monetary tightening has had a bearing on GDP growth. The Reserve Bank of India (RBI) recently cut the cash reserve ratio (CRR) by 50 basis points. Given this, would you still believe that now is not the right time for a rate cut?
India’s high level of inflation shows that there is not a lot of excess capacity in the economy, and cutting now could add to price pressures. Expectations of future inflation are also high, and inflation expectations are often self-fulfilling. Also, the depreciation of the rupee has begun to pass through into higher domestic prices, but this process is not yet complete. The decline in inflation so far has been due to base effects, so it is important to ensure that inflation comes down durably before reducing interest rates.
IMF has projected India’s 2012 GDP growth forecast at seven per cent, lower than 7.4 per cent in 2011. However, RBI expects growth to be little better in fiscal year 2012-13 than in the current fiscal. Given that inflation is easing and RBI is expected to go easy on monetary tightening, wouldn’t all this mean that growth will get a boost?
We expect investment to pick up next fiscal, but this is likely to be countered by slowing exports. Overall, we expect growth to be about the same as this year.
What will be a bigger issue for India to manage going forward — the current account deficit or fiscal deficit?
Cutting India’s fiscal deficit is a priority. We expect this year’s deficit to exceed 5½ per cent of GDP, pushing up interest rates, making investment more expensive and reducing the flexibility of RBI in setting policy rates. In the long run, a smaller deficit would reduce the government’s demands on savings, allowing banks to make more loans to firms and households. We expect the current account deficit to remain close to its historical norms at around three per cent of GDP.
The euro zone is expected to end up in a recession in the coming quarters. How hard will India be hit as a result?
As we saw in 2008-09, India is not immune to global problems. While we do not foresee a severe recession in the euro zone, we are watching two channels. First, demand for Indian exports would be hit, both to the euro zone itself but also to countries whose economies depend strongly on euro zone demand for their own exports. Second, many of the world’s largest banks are European. These banks are already focusing their business back on Europe, making borrowings such as trade credit more expensive for Indian corporations. Much of the slack is now being taken up by banks from other regions, though at a higher cost.
The US economy is finally showing some signs of improvement in its macro indicators. What will happen to the US if the euro zone slips into recession, will there be a setback given that no clear policy is visible to resolve the issue on a long-run basis?
A euro zone recession could have serious implications for the US economy. As for a long-run solution in Europe, these agreements take time, but progress is being made.