For over a year now the Reserve Bank of India has been engaged in monetary tightening to contain inflation. While that remains stubbornly high, there is a clear deceleration in the growth rate, putting paid to hopes of starting off the next plan on the elevated path of 9 per cent growth. The inflation and lower growth are being cited together as symptoms of all not being well with the Indian economy, which has been a star performer in recent years. A clear distinction is not being made between the two – inflation and lower growth – even though the former is the disease and the latter a side effect of the medicine used to fight it.
In fact, there is not much sign of satisfaction that the policy rate instrument is working quite effectively, doing what it was supposed to do – suppress demand. The fact that the ultimate aim of tightening, sharply bringing down the inflation rate, has not yet been achieved has not raised doubts about the efficacy of the medicine. Over time it will achieve the desired effect, but possibly at great cost. The initial impact on consumer demand and sentiment will translate into a downswing in business sentiment, resulting in a cutback in investment expenditure (gross fixed capital formation has begun displaying negative signals). If this consolidates, it will slow down growth for several years as had happened after the tightening of 1996.
The finance minister has already expressed the first sign of worry: if the slowdown becomes pronounced, it will affect revenue buoyancy, render awry his fiscal projections and raise a question mark over future fiscal stability. With a slowdown in capacity creation, the export surplus may diminish, affecting the current buoyancy in exports. All this will have the most negative of social consequences — job growth will suffer and with it the battle against poverty.
With so much at stake, it is necessary to re-examine the basic tenets of the anti-inflationary regime that is being followed. Even if there isn’t much scope for change, a detailed look can help clarify priorities — what are the goals and what is the price that can be paid to achieve them? The root of the present inflationary episode is threefold: the rural employment guarantee programme since 2006 imparting a sharp rise in demand for food, the drought of 2009 impacting food output and the rise in global oil prices through 2010, accompanied by a hardening of commodity prices. The rise in the fiscal deficit through 2008-2010 is not seen as inflationary since it owes its origins to the stimulus imparted to counter the global slowdown in the wake of the financial crisis, and insulate the Indian economy from its consequences.
As food inflation lies at the core of the present inflation and the employment programme is likely to sustain a high demand for food, the key to tackling the supply-induced part of inflation surely lies in vastly improving agricultural management. Policy failure on this front is the starkest but the positive side is that the list of things that need to be done is both obvious and widely understood. Improved water management leading to better drought-proofing, shifting the thrust of procurement to coarse cereals and rain-fed areas, taking forward the reform in fertiliser prices to restore soil nutrition and storing grain better so that rodents don’t get to it — all this is doable at short notice with a likely quick positive impact on supply.
The other area where immediate action is possible is countering what goes under the broad rubric of fiscal profligacy and particularly cutting energy subsidy. The positive impact will be twofold: non-productive current expenditure will be partly reined in and by pricing energy right the correct incentive and signal will be transmitted to raise energy efficiency. Additional gains can be reducing the incentive for diversion of kerosene, driving the oil mafia out of business and removing the perversity of subsidising diesel-powered luxury cars.
But for many the need to contain fiscal profligacy also includes arguing against the employment guarantee programme and the right to food security and education. If a job creation scheme is used to construct public assets like tanks, irrigation bundhs and rural roads, and public transfers lead to undernourished poor people being better fed and receiving a minimum of education, then the picture changes. India’s inability to create large numbers of low-skilled manufacturing jobs is rightly laid at the door of its inflexible labour markets. But it is forgotten that countries like Japan, Korea and China all followed the route, now being adopted by Vietnam, which gave them well-fed, healthy and educated workers before the jobs came. So, having a clear idea of what is wasteful non-productive public expenditure is vital to attain the right policy mix.
All the foregoing actions should take precedence over that favoured policy instrument of monetarists — raising interest rates. When inflation is caused by a shortage of essentials, or when it results from policy intervention for public transfers to empower the poor, raising interest rates is foolhardy. It ends up extending investment horizons and adding to manufacturing costs. It is like a doctor prescribing a primitive first-generation drug with many side effects. It is necessary to live with some inflation, that which is caused by a net transfer to the poor which eventually leads to a more productive workforce. The simplistic mantra – inflation sighted, ergo raise interest rates – needs to be countered.
