Once upon an 8%
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Conducting fiscal and monetary policies in what appears to be a phase of stagflation can be a huge challenge for any government. Even economic literature seems unclear on how you deal with a situation when growth dips sharply and the inflation rate remains stubbornly high. After dithering for nine months, the RBI finally decided to cut the repo rate (interest rate at which the central bank lends overnight to banks) as a signal that it was willing to recognise the risk to growth as a more dominant concern than the persisting problem of inflation. The RBI pleasantly surprised the market by cutting both the repo rate and the cash reserve ratio (CRR) of banks by 25 basis points each. The central bank probably got a bit alarmed that, on a sequential basis, GDP growth in the third quarter of 2012-13 may actually be down to 4 per cent, which seems closer to the old Hindu rate of growth seen in the 1960s and '70s. The RBI, therefore, decided this time that it would shift its focus largely to growth risks. It was possibly this change in thinking that resulted in a surprise reduction of the repo rate and the CRR.
The stagflation-like situation (so far, nobody is officially admitting to stagflation, though we have had 15 months of persistently high inflation and falling growth) had also created a sort of gulf in communication between the Centre and the RBI. The RBI had primarily remained focused on inflation risks through 2012, and the then finance minister, Pranab Mukherjee, just could not get the central bank to look more at the dramatic decline in growth from the 2010 peak of over 8 per cent.
The central bank's stance was that it could ease monetary policy only if the finance ministry showed it was serious about controlling the runaway fisc and helped in managing food inflation through better supply measures. RBI was clear that money supply could not be eased when inflation risks were persistent. For a while, the RBI refused to budge from this position, even after Finance Minister P. Chidambaram took charge last August and gave a public commitment to rein in the fisc. In my view, there were two major factors that enabled the central bank to finally take the decision to cut the repo rate, after a hiatus of nine months.
One, Chidambaram managed to convince the RBI that he was dead serious about keeping the fiscal deficit target at 5.3 per cent of the GDP for 2012-13, even as analysts were sceptical about this being possible. Observing the overall scepticism about the government's ability to cut expenditure, Chidambaram decided to become a bit aggressive and chose to publicly announce he would bring down fiscal deficit to 5.3 per cent. This was somewhat unorthodox as finance ministers normally show their hand only during the budget presentation. Chidambaram probably chose to do it in Hong Kong, one month ahead of the budget, to win the confidence of the global markets as well as of the RBI. This was his way of telling the RBI that the Centre was walking the talk on fiscal and other reforms.
The second factor that may have impressed the RBI was the government's decision to leave oil companies free to raise diesel prices in small doses over the next 24 months. Earlier, the RBI had been citing the Centre's inability to correct oil prices as one of the reasons for not being able to ease monetary policy. The UPA surprised everybody, including the RBI, with its decision to correct diesel prices.
The diesel price increase is important from another important perspective. India badly needs to discourage, through rational pricing, the consumption of oil products because of its ever widening current account deficit (CAD), which touched an unprecedented 5.4 per cent of the GDP in the second quarter of 2012-13. For the financial year 2012-13 the CAD is estimated to be very high, at over 4.5 per cent of the GDP. This is way higher than what the policy-makers regard as a safe current account gap (what India pays in foreign exchange minus what it receives from abroad annually).
Both the RBI and the finance ministry have been very worried about the quality of the widening current account gap, which could be over $80 billion in absolute terms in 2012-13 end. The RBI's analysis shows that, for much of the last decade, when the current account deficit was under 2.5 per cent of the GDP, the gap could be met fully with pure foreign direct investment flows, which is the most stable form of capital flow. This was the case until 2007-08.
However, with the current account gap dramatically doubling over the past two years, FDI flows can meet only 25 per cent of the annual foreign exchange deficit. This is a serious risk because in 2012 we have depended on the more fickle stock market inflows through FIIs (about $25 billion) to partly fill the foreign exchange deficit on the current account. If we face one year of low FII inflows, which has happened in the past, there would be a heavy drawdown from forex reserves held by the RBI. The exchange rate could then become highly volatile.
The current account risk is exacerbated by the fact that much of the deficit has been caused by rising oil and gold imports. Non-oil and non-gold imports are actually declining. That is really bad news from the standpoint of productivity. Oil imports are now over $140 billion annually and gold imports are likely to be over $35 billion, despite government's efforts to discourage it. Gold is seen as unproductive savings from a macroeconomic perspective.
More than ever before, India needs to discourage the wasteful use of petroleum products through subsidies. Higher diesel prices will discourage excessive use and if we manage to cut the oil bill by $10-15 billion a year through rational pricing, the stress on the current account will be reduced considerably.
As for gold imports, the government is using higher import duty as a devise to cut foreign exchange outgo on gold. This may have limited efficacy as it would encourage smuggling of gold and revive hawala.
A more lasting solution, really, is to revive growth and confidence in the economy so that investors move away from gold as a hedge against inflation. You can't really blame investors rushing to buy gold because most equity mutual funds have given returns of about 5 per cent annually over the past five years, a negative real return of 4 per cent. No wonder people have faith only in gold and real estate as means to protect their savings from inflation.
All these problems will automatically wane if confidence in the economy is restored by bringing growth back on track. Indians are fast losing the memory of 8 per cent GDP growth, such has been the psychological impact of stagnation accompanied by inflation these past few years. The forthcoming budget will simply have to do everything to revive growth. All other things will automatically fall into place.
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