Shyam Ponappa: Growth without sacrifice

India should initiate disinflation while the going is good.

There is a pervasive belief that inflation can be reduced only at the cost of giving up growth, despite evidence to the contrary. A major determinant of results as seen in other countries is the policy mix and instruments used to reduce inflation and promote growth. The key to effective solutions appears to be identifying causes and formulating effective solutions with minimal negative consequences, not rote responses. This applies to managing capital inflows, too.

The RBI published a study in 2003 on the estimated loss of output for reducing inflation in India.* The report calculates the sacrifice ratio, defined as the loss in output (or employment) for a 1 percent reduction in inflation as a deviation from the trend GDP. The report presents a survey of the literature together with data from India, with estimates of losses for disinflation. While the report acknowledges that lower inflation rates would be most beneficial in the long term, it argues that such efforts reduce GDP growth. The report estimates India's sacrifice ratio using the WPI inflation rate for the period 1970-71 to 2000-01 at 1.9-2.7 for each percentage point reduction in inflation. Using the GDP deflator, the sacrifice ratio is estimated at 2.6-3.5. An earlier report by the RBI in 2002 based on the WPI estimated the sacrifice ratio at 2.

Perhaps a limitation of these studies was their consideration of OECD data, and not data for developing countries. With the extent of India's growth since then, it would be interesting and useful to know if the RBI has done more research in this area. 

Average Sacrifice Ratio for 1% reduction in Inflation
	Average Output Costs		Output costs per year		Output cost of reducing inf by 1/2
	Ball	LL&II	Ball	LL&II	Ball	LL&II
70s & 80s	3.5	6.3	1.1	2.6	3.6	7.3
90s	-1.3	-9.8	-0.1	-2	-0.5	-0.5

There are contrary data from developing countries as well as some developed countries. The IMF's World Economic Outlook, May 2001, noted that in countries that used inflation targeting for several years (Chile and Israel among emerging markets, and Australia, Canada, Chile, Finland, New Zealand, Spain, Sweden, and the United Kingdom), the sacrifice ratio was estimated at 0.6. For emerging market countries that adopted inflation targeting for two years (Brazil, Colombia, Korea, Mexico, and South Africa), the average sacrifice ratio was slightly negative (-0.4).** Both figures are substantially lower than benchmark estimates for sacrifice ratios in advanced countries.

A report by the Central Bank of Turkey in 2002 found that contrary to expectations, there was no significant loss of output for disinflationary episodes in Turkey. *** Inflation, growth and unemployment in Turkey since 2000 are shown in Figure 1.

A study of 18 Latin American and Caribbean (LAC) countries including Brazil and Mexico for the period 1973 to 2000 found that while there were output losses during disinflation in the 70s and 80s, disinflation costs in the 90s were on average negative (Table 1).# Table 1 shows estimated losses in output in the LAC using two methods. Lawrence Ball's method assumes output loss in only one period following the starting level of inflation. The Long-Lived effects and Inflation Inertia method (LL&II) allows for a gradual return to trend. The negative sacrifice ratios for the 90s show that there was no loss in GDP growth.

The study posits that the reasons were a combination of large capital inflows, structural reforms, and a previous period of high inflation.

India's case

India needs to devise ways to handle large capital inflows that are causing undue currency appreciation and inflation. One aspect is the long-term response of structural reforms, to enable efficient conversion of funding to productive projects, i.e., increasing supply. A second is of appropriate responses to mitigate short-term pressures, i.e., not automatically raising interest rates or defending the exchange rate, but taking coordinated fiscal and monetary action to contain excess liquidity (which might include possible actions on interest and exchange rates). Nor does credit growth at 30 percent necessarily deserve clamping down; however, limitations of space compel me to defer exposition to a future article.

For example, one way to address inflows is as an asset-liability management issue, i.e., a financial management requirement in all sound banks. Asset-liability gaps are estimated and managed by deploying temporarily 'excess' funds in remunerative short-term investments, with continuous monitoring and action to meet liquidity needs. While conceptually simple, successful practice requires considerable skill in asset-liability gap estimation and in asset management. Capital flows involve additional complexities, such as offshore handling, structuring, and knowledge of different markets, currencies and asset classes. An important caveat is that there is no substitute for real expert skills. Investments need to be made in liquid assets through approved fund managers. If there is liquidity pressure, these assets can be cashed.

If we can reduce currency appreciation and liquidity pressure by redeploying some of the 'excess' capital inflows abroad in liquid, high-paying investments on the lines of well-managed American endowments, we will have achieved lower exchange rates beneficial for exports, while reducing pressure from the flows""i.e. temporary demand"" on the rupee to appreciate, yet retain the ability to mobilise and repatriate funds if there is a threat of a liquidity crisis.

These tasks have to be addressed explicitly, by designing and setting up institutions and systems with the requisite competences. The wrong way would be to recreate a government-owned fund like the UTI with its attendant stream of problems. Nor can committees of academics, parliamentarians, or ministers manage such tasks. However, the initiative certainly needs to be political, and preferably by a multi-partisan, empowered committee, aided by experts with a practical, problem-solving bias. Expertise in many dimensions has to be brought together and coordinated for these initiatives, inducting imaginative ideas while avoiding inappropriate models. The skills needed are in planning and evaluation with probabilistic cash flows, gap and investment management, creative structuring, knowledge of markets and players, with a strong systems orientation.

Incremental gains from investments abroad can be substantial. The top endowments earned over 20 per cent in 2006 (MIT earned 23%; Yale, 22.9%). A net 15 per cent on $150 billion would earn about Rs 90,000 crore each year, or Rs. 7,500 crore a month.

This is why a multi-partisan initiative to start a sovereign investment fund to be set up and run professionally would be timely and highly beneficial.

* "The Price of Low Inflation", Muneesh Kapur and Michael Debabrata Patra, January 2003: http://rbi.org.in/scripts/PublicationsView.aspx?Id=4680
** http://www.internationalmonetaryfund.org/external/pubs/ft/weo/
2001/01/pdf/chapter4.pdf *** "Calculation Of Output-Inflation Sacrifice-Ratio: The Case of Turkey," A Arzu Cetinkaya and Devrim Yavuz, November 2002: http://www.tcmb.gov.tr/research/work/wp3.pdf # "Disinflations in Latin America and the Caribbean: A Free Lunch?", Marc Hofstetter, March 1, 2004, Johns Hopkins University and Universidad de los Andes: http://www.econ.jhu.edu/pdf/papers/wp506hofstetter.pdf