The prospects for an enduring global recovery have increased recently, further bolstering the case for policy tightening in emerging economies that have recovered faster. Asia has consistently led this recovery. In recent months, however, the outlook for advanced economies has also improved some. In particular, while some risks, such as weak fiscal and banking balance sheets in Europe and the housing market in the US, remain ongoing concerns, a successful handover of domestic demand from the public to the private sector is taking place. With the global recovery thus becoming more entrenched, it is appropriate for attention in our part of the world now to shift policies more pressingly towards the signs of overheating that are emerging.
In our recently-released Asia-Pacific Regional Economic Outlook, we envisage that, on average, Asia will grow by 7 per cent during both 2011 and 2012, led once again by China and India. Sequentially, this reflects a gradual acceleration of growth through 2011. For India, our comparable growth projection (i.e. for calendar 2011 at market prices) is for 8.2 per cent, which translates to 8 per cent for FY 2011/12 on a factor cost basis. As in the rest of Asia, growth in India has been supported by strong exports that have benefited from greater final demand from emerging economies. Indeed, in recent years, India’s exports to emerging and developing economies have exceeded those to advanced ones. In India, as in some other Asian countries, growth has also been supported by favourable financial conditions — low real interest rates and bank credit that has surpassed the authorities’ targets.
However, India also shares with other Asian countries the risks posed by rising inflation. Annual headline inflation for the Asian region as a whole increased by about half a percentage point in the three months to January 2011, with India especially hard hit. In countries such as India operating close to or full capacity, core inflation has also risen rapidly, as have inflation expectations across the region. Furthermore, given global concerns about oil supply and the welcome development of rising incomes increasing Indian demand for food, the risks to inflation remain on the upside. Our past analysis has shown that food inflation feeds into higher non-food inflation in many lower per capita income countries, including India. The fact that food inflation hits the poor hardest only strengthens the case for tighter monetary policy in India and across the region.
Overheating in Asia is also leading to rising pressures in regional asset markets. Credit dynamics have been especially strong in China, while property markets remain buoyant in some places. Also, capital flows, attracted by Asia’s strong prospects, have been strong in this recovery, leading to historically high bond and equity valuations, at least until the recent pullback. Such inflows, while on the whole a positive development, can add to price pressures in asset markets and lead to economic instability.
The Indian authorities recognise well the new challenges and have moved to face them squarely. The RBI has been increasing interest rates since early 2010, and its decisions announced on May 3 are most welcome as they clearly show the central bank’s determination in fighting inflation. Nevertheless, with real interest rates still below historical norms, policies should continue to bring inflation and inflation expectations closer to the RBI’s medium-term inflation objective. The RBI has also moved to address incipient pressures in the real estate market by tightening prudential norms. As we argue in our economic outlook, macroprudential measures, such as those taken by the RBI, have a useful role to play in reducing economic instability but cannot substitute for monetary tightening. Finally, within the context of a well regulated and stable financial system, India has seized the opportunity to harness capital inflows to finance infrastructure spending through bond sales while minimising the risks of their sudden outflow.
The budget for the current fiscal year, if implemented as envisaged, will also help to address overheating and inflation. However, reaching this year’s deficit target will be more challenging than attaining last year’s. Last year, one time proceeds from the wireless spectrum auctions provided a large cushion that could be used to raise spending without requiring additional borrowing. But this raised the bar for 2011/12: with spending budgeted to rise only slightly above last year and no such cushion, revenues will have to make up the difference. And beyond this there are other problems: high oil prices mean that fuel and fertiliser subsidies, unless reformed, will present a drag on the budget again this year. Higher NREG wages, the ongoing RTE rollout, and the effect of higher food prices on food subsidies will also have fiscal costs. Increasing efficiency, whether through the UID for example, or moving to direct cash transfers for fertiliser and kerosene subsidies, can help over time. But, over the next few years, reaching India’s deficit goals will require the rationalisation of expenditures, including subsidiies, and a strong focus on spending in those areas most important to India’s infrastructure and social goals.
The author is Director, Asia and Pacific Department, International Monetary Fund
