By Prem Shankar Jha
THERE HAS been good news and bad news for the Indian economy in the past two weeks. The good news is that Prime Minister Manmohan Singh has taken personal charge of the finance ministry. This has given investor confidence a much-needed shot in the arm by concentrating power and responsibility, at last, in the hands of the man at whose table the buck finally stops. That he is the very person who ushered in, and skillfully guided, India’s reforms in 1991, has heightened expectations of decisive action to tackle the root causes of the current economic crisis. The bad news, however, is that there is still no consensus on how it should be tackled.
The crisis began with a slowdown of growth but has developed into an all-embracing decline and a loss of confidence in the government’s capacity to manage the economy. The first unmistakable signal was the fall in the GDP growth rate from 8.4 percent in 2009-10, and 2010-11, to 6.5 percent in 2011-12. Before leaving the finance ministry, Pranab Mukherjee defended this by reminding us that it was still among the highest growth rates in the world. But what he could not brush away was the fall in industrial growth from 8.2 percent in 2010-11 to 2.8 percent last year and the 3.2 percent contraction of industrial output between January and March this year.
The crisis has enveloped every other part of the economy. At April-end, export growth had fallen from a healthy 33 percent in 2010-11 to 20 percent. This fall, too, has taken place almost entirely in the past six months when exports grew by only 2.4 percent. However, imports have continued to grow strongly. This has widened the balance of payments (BoP) deficit to nearly 4 percent of the GDP, a gap not seen since the crisis years of 1989-92.
The slowdown of exports coincided with, and happened in spite of, a 27 percent fall in the value of the rupee that had begun in July 2011 and should, in theory at least, have boosted our exports. This rate of depreciation, too, is a first in our post-1991 economic history.
The challenge that Manmohan faces is, therefore, unequivocal: it is, first, to revive confidence in the future of the economy and stem the fall of the rupee; second, to revive not only economic, but specifically industrial growth; third, to speed up the growth of exports and close the widening trade gap; and fourth, do all this at least without increasing, even if he cannot bring down, the rate of inflation. Unfortunately, all the indications coming from key officials in the finance ministry and the PMO show that the government does not have any answers.
In a forthright and thoughtful analysis of the government’s options published on 9 July inThe Economic Times, the prime minister’s economic adviser, C Rangarajan, said that growth was being held back by supply shortages caused by poor infrastructure, and a weakening of investment. When asked whether the latter could be redressed by lowering the rate of interest as European banks were doing even now, he said, “They have slow growth but a low rate of inflation. We have slowing growth and a high rate of inflation.” Interest rates, he asserted, could not be brought down till inflation, which is running at 9 percent, came down.
When asked what the government could do to reduce the gap in our BoP, Rangarajan tacitly admitted that various measures to make foreign investment easier in government bonds — and in the share market — had failed to evince much response from foreign investors.
The solution, therefore, lay in reducing India’s imports. To some extent, this would happen automatically because the current squeeze on profits and earnings would reduce the import of gold. But the government had plans to increase the output of coal and reduce its import hoping that the deepening recession in Europe and the sharp downturn in China would bring international oil prices down as well.
The crux of the challenge, Rangarajan conceded straightaway, is in reviving investment. But this has to be done without raising the fiscal deficit, (which has climbed steadily to 8 percent of the GDP for the Centre and the states), and increasing the deficit in our BoP. The only way is to shrink the subsidies that have ballooned over the past eight years. If this is done, India will recreate the “fiscal space” to increase investment without running the risk of causing inflation or further widening the gap between our exports and imports.
Rangarajan’s analysis cannot be faulted: it is only when he comes to solutions that questions begin to arise. The first is the absence of any indication in his analysis of precisely how the “fiscal space” will get translated into investment. His emphasis on the constraints posed by the lack of infrastructure, and the government’s recent orders to public enterprises to stop earning returns by keeping their surpluses in banks and start investing it instead, suggest that the government has tacitly ruled out trying for a spontaneous revival of private investment and intends to rely upon Stalinist diktats to get the public sector investment started again.
Absent from this is any reflection on why the public enterprises, and private firms too, are preferring to sit on their money instead of investing it. Indeed, commercial banks have been flooded with such huge bulk deposits, and have so few borrowers, that they are refusing the money that is being offered to them. The obvious reason is that industry is suffering from a lack of orders because there is a general unwillingness to invest. The moment we ask why, we come back full circle: the high interest rates prevailing in the economy.
Manmohan Singh has to bring about an economic revival without increasing, if not bringing down, inflation rates
While not quite as adamant as Reserve Bank of India (RBI) Governor D Subbarao, Rangarajan firmly believes that inflation has to come down before interest rates can be lowered. “We have never tolerated 9 percent inflation rate in our country,” he points out. At the very least, he adds, inflation in non-food manufacturing must come down first. These remarks are surprising, to say the least, on several counts.
The first is his interpretation of the data on the current rate of inflation. According to the latest release from the Central Statistical Office, inflation was running at 7.55 percent at the end of May, but the inflation in manufactures was a whole 2.5 percent lower at 5.02 percent and the inflation in non-food manufactured products was even lower at 4.86 percent.
Second, this inflation is not a product of excess of demand but of a rise in the cost of imported inputs caused by the depreciation of the rupee. The ratio of raw materials imports to gross industrial sales is about one-third. Thus, even if only half of the 27 percent fall in the value of the rupee has percolated into the cost of production, it will already have pushed up manufacturing costs in the non-food sector by 4-5 percent.
It is more than likely, therefore, that outside of a few energy intensive industries such as steel, non-ferrous metals and cement, where the increase in prices can be traced back to a rapid increase in energy costs, there is little or no demand-induced inflation in industry today. This finding would be entirely in line with the rapidly dropping investment and the contraction in manufacturing output.
Third, and most surprising is Rangarajan’s unwillingness to distinguish between inflation caused by an excess of demand — which can, but does not always follow, a sharp increase in money supply — and inflation caused by shortages of supply, such as those caused by a drought, adverse weather conditions, the exhaustion of global reserves, or a sudden rise in demand for globally traded commodities in another country, as witnessed during China’s $1.8 trillion investment spree in 2009 and early 2010. Raising the interest rates and thereby curbing the growth of money supply can moderate demand-inflation. But it cannot affect cost-push inflation whose causes, by definition, lie outside the control of any single national monetary authority.
Like the past two RBI governors, Rangarajan too seems to have overlooked an implied premise of Milton Friedman’s model of the relationship between inflation and money supply. This is the assumption of long-term general equilibrium.
In practice, this means that the one-to-one relationship between money supply and prices only holds over a long period of time. Within that period, a high fiscal deficit will translate directly into higher prices only when the economy comes close to full capacity utilisation. The relationship ceases to hold when growth stalls, consumer demand declines and capacity constraints on production disappear. Cutting back government expenditure then only has the effect of further slowing down growth, shrinking the tax base and keeping the fiscal deficit wide open. This is what Europe did to itself and is belatedly trying to undo now.
LOOKING BACK over the experience of the past six years, it is clear that nothing has harmed the economy as much as the RBI’s refusal to distinguish between the two types of inflation. India had suffered incessantly from demand inflation throughout the years of the command economy. But the cause then was a liberal resort to deficit financing in the face of a perennial shortage of essentials, and its after-effects lingered till 1997-98, when the country plunged abruptly into a recession.
In sharp contrast, when inflation breached the 5 percent safety limit again in 2006, it was no longer being impelled by excess demand but by a poor monsoon, shortages of fruits and vegetables, and shrunken buffer stocks of cereals. In December 2007, these supply-side pressures sharpened abruptly because of a drought in Australia, the diversion of a large part of the American maize crop to the production of ethanol, China’s voracious demand for raw materials, as the frenetic investment boom that had begun in 2002 reached a peak, and a sharp rise in oil prices to $150 a barrel, before the onset of the global recession.
But the RBI refused to distinguish between the two types of inflation and continued to treat the price rise as a demand inflation caused by a rise in money supply and continued to increase interest rates every two months on an average, till it was caught flat-footed by the global recession in August 2008.
When it comes to reducing the gap in the BoP, C Rangarajan admits that the solution lies in reducing India’s imports
The fiscal stimulus of 2008 and 2009 resulted in the sharpest industrial recovery India has ever experienced, but without any inflation. The reason, again, was developments outside India that the RBI did not influence or control — notably a 60 percent fall in commodity prices and a 70 percent fall in the price of oil. But the RBI drew no lessons from this experience either. So when the Chinese investment splurge of 2009 hardened commodity prices towards the end of the year, the RBI revived the bogey of inflation and, from March 2010, started to raise interest rates once again.
But this time, it did so with an added twist. In several of its quarterly policy statements, the RBI explicitly linked its future interest rate policy to the rate of inflation, irrespective of its cause. To foreign institutional investors, this made India the most dangerous place in the world to invest in, because it linked the fate of their investments to developments that they could neither predict nor control. This was the cause of the steady withdrawal of foreign institutional investors that began in July 2011, and brought down India’s foreign exchange reserves by $14 billion during the fiscal year.
WHERE SHOULD we go next? However one may differ with the government’s handling of the economy in the past, the starkness of the challenge it faces now leaves relatively few options and, therefore, relatively little room for disagreement. We can no longer afford the luxury of procrastination or trying out half-measures dictated by political expediency. Both theory and practice have taught us that there are only two ways of reviving demand — by increasing government spending to stimulate consumption, or by lowering interest rates to stimulate investment. The Centre’s 8 percent fiscal deficit rules out the first, so the second is the only option that remains open.
Past experience, in the US in the 1990s and here in the early 2000s, tells us that lowering interest rates will not only revive industrial growth but speed up the growth of tax revenues, and start to bridge the budget deficit on its own. This was the first part of the NDA government’s strategy when it halved the prevailing interest rates between 2000 and 2002.
The other part was the passage of the Fiscal Responsibility and Budget Management (FRBM) Act, which laid out a roadmap for reducing the budget deficit over a period of time. The result was an investment explosion in 2003-04 that allowed India to leapfrog onto an 8 percent growth track.
It is to the NDA regime’s credit that it more or less adhered to the FRBM’s timetable for reducing the deficit. But the UPA government did not, and instead went on a spending spree even before the global recession gave it an excuse to do so. Nor did the spending stop after the recession had been averted. The right moment for unveiling a programme to reduce the fiscal deficit was the presentation of the 2011-12 Budget. But by then, the populists in the Congress had the bit between their teeth, and a spate of new spending commitments have more or less been forced upon the government by diktats from the party. As a result, the Centre’s fiscal deficit rose from 4.9 percent in 2010-11 to 5.9 percent of the GDP last year, and the consolidated deficit of the Central and state governments touched 8 percent.
This profligacy must not be repeated. Whatever its past errors might have been, today, the RBI is right in insisting that a clear and substantial cut in the fiscal deficit must accompany the lowering of interest rates. If interest rates are lowered first and investment revives, it may not only blunt the willingness of the Congress to undertake fiscal reform, but trigger demands by the radicals for a fresh spending spree on “inclusive development” that Manmohan may not be able to prevent.
Reducing the fiscal deficit is easier said than done. The simplest and most effective way would be to reduce the plethora of subsidies that the government doles out every year. In 2011-12, the subsidy on just three products — food, petroleum products and fertilisers — added up to Rs 2.16 lakh crore. But since it is taken for granted that subsidies go to the poor, it is also assumed without question that cutting them will hurt the poor and, therefore, be exceedingly unpopular with the electorate.
In spite of this, the Manmohan regime has been courageously battling to lower petrol subsidies by raising oil product prices, mainly of petrol and LPG. But a mini-revolt among urban white-collar workers against another hike in petrol prices has brought it to the end of that road. The revolt is not surprising because between May 2010 and May 2012, while the price of diesel in Delhi rose from Rs 38.10 to a little over Rs 41 per litre, that of petrol rose from Rs 47.93 to more than Rs 73.
As a result, while the urban middle class is blaming the government for its woes, the truly rich have effortlessly switched to buying diesel-guzzling SUVs. Today, 45 percent of the new cars being purchased are powered by diesel. As a result, the finance ministry is seriously considering raising the excise duty on diesel vehicles.
In his interview to The Economic Times, Rangarajan dismissed the proposal as relatively ineffective and said that there is no option but to take the difficult decision to raise the prices of diesel and LPG. A number of eminent economists and captains of industry have also urged the government to reduce the gap between petrol and diesel prices by raising only the latter. But for sound political and economic reasons, it would be far better to do this by both raising the price of diesel and simultaneously lowering the price of petrol.
The reason is that the stereotypes that have governed our perceptions and policies forever since Independence are no longer valid. Diesel is no longer solely the poor man’s transport fuel, and petrol is most definitely no longer the preserve of the rich. While buses accounted for less than 12 percent of the 60 million tonnes of diesel that was consumed last year, passenger cars accounted for more than 15 percent.
Another 18-20 percent was used to generate auxiliary power for industry and private homes. Truck transport, which accounts for just over a third of consumption, may be the most sensitive sector as fuel makes up an estimated 60 percent of operating costs. But since transport costs account for less than 10 percent of the retail price of most products, a 20 percent hike in diesel price will translate into, at most, a 1.2 percent rise in the cost of living.
On the other hand, almost 30 percent of households in the country now depend on petrol-driven vehicles to meet their transport needs — 55 million on two-wheelers and 12.3 million on cars. Unlike diesel prices that affect the cost of living only indirectly, through the production chain, petrol price hikes impact final consumption directly. Assuming that the average scooter or motorcycle owner uses two litres of petrol a day, the Rs 25 price hike of the past two years has reduced his or her family’s disposable income by Rs 1,500 a month. This makes the mini-revolt that the government faced last month easier to understand.
Reducing fiscal deficit is easier said than done. The most effective way is to reduce the subsidies the government gives
The moral of the story is clear: the negative political impact of any diesel price hike can be more than offset by the positive political impact of an equal reduction of petrol prices. Since the consumption of petrol is less than a quarter of diesel, lowering the current price of petrol by 10 a litre and raising that of diesel by the same amount will reduce the subsidy bill by approximately Rs 62,000 crore.
A second long overdue reform that can also reduce subsidies by at least Rs 25,000 crore if properly designed, is the abolition of the ration card-based Public Distribution System (PDS) and its replacement by food stamps — mailed or otherwise sent directly to the beneficiary. This reform will stop the rampant corruption in the PDS. According to the last National Sample Survey, the average BPL family is buying only 4.6 kg of its quota of 25 kg (of rice/wheat) a month at the stipulated price of Rs 2 per kg, and one litre of the five litres of kerosene it is entitled to, at the PDS shop. The common practice in these shops is to give the beneficiary a part of his or her quota free of cost, and sell the rest in the open market. As for kerosene, it is now used even by the poor almost solely as a lighting fuel. Two-fifth of total production is diverted to the adulteration of diesel, and yields approximately Rs 12,000 crore a year to the gas station mafia in rural areas.
Introduction of food stamps was one of the UPA regime’s very first promises in 2004. Pressure from the food surplus states forced it to abandon the scheme. If it wants to come back to power in 2014, it still has two years to fulfil its promise.
Prem Shankar Jha is a senior journalist.