Inflation vs. Growth – Which side India should be?

Posted in Finance Articles, Total Reads: 2290 , Published on 12 April 2013

The seemingly mutual exclusivity between inflation and growth has been the point of inflection between our Reserve bank and our Finance Ministry. It has become a standard recipe for argument and alibi which has paralyzed reforms in a country, which caught the undivided attention of the world in the last decade, courtesy its unparalleled growth in excess of 8% from 2003-2008. We need to understand as to what stokes the twin phenomena of growth and inflation.

Inflation is a function of both demand and supply forces which are determined by monetary and fiscal regulations that constitute policies pertaining to interest rates, subsidies, direct and indirect taxation, foreign investment et al. India is largely a consumption driven economy. It enjoys a perennial source of consumption demand, from its teeming billion plus populace, which is fairly resistant to monetary and fiscal changes. What must be noted that the gross domestic savings of the country has increased by more than 30% from 2009 to 2011 dwarfing the growth of consumer price index which clocked 25% during the same period.

Moreover consumption in rural areas is growing at a faster pace as compared to the urban counterparts. Underpinning this growth in rural consumption is a strong increase in rural incomes due to rising non-farm employment opportunities and the government’s rural focus through employment generation schemes. For sustaining the rural boom, it is critical to substitute short-term income boosters such as government-sponsored employment guarantee schemes with durable job opportunities in rural areas. These can only be created through necessary investments in the transportation, communication and education infrastructure. A notable phenomenon in rural consumption is a shift from necessities to discretionary goods. Moreover, for India, a young population, rising income and low penetration of many consumer durables means that rural consumption has the potential to remain an important source of demand. This demand needs to be harnessed and not stifled.

What needs to be addressed is the supply chain bottlenecks which would create a sustainable condition akin to China where on one hand, there is consistent double digit growth while on the other hand, the inflation modestly dangles at less than 5%. What needs to be understood is that persistently high inflation pushes up interest rates, reduces savings and impacts long-term capital decisions — negatively impacting growth rates of investment-driven economies. Additionally, the lack of capital investment prevents the supply-side constraints from being addressed. Thus, high inflation lurks alongside subdued growth rates. This combination, in the extreme, creates “stagflation” which is what India is saddled with today. The 12th year 5 year plan envisages a trillion dollar investment in infrastructure but considering that the Indian government is currently running up a mounting fiscal deficit in excess of 5%, these investments could be conveniently put on the backburner, thus hurting growth and development. What’s needed is not monetary tightening but pulling the plugs on the fiscal subsidies. As per a working paper by RBI, it should be noted that a hike in interest rates impacts investment demand more than the consumption demand. Moreover, over the last few years, the gap between WPI and CPI is widening primarily on account of differing weights (particularly as far food and other primary articles are concerned). In the last 3 years or so, RBI has hiked the interest rates almost 13 times. However it hasn’t had a proportionate impact on the food and non-food inflation in the country. RBI hikes rates to lower discretionary consumption, decrease imports, stem rupee depreciation and bring down commodity prices. However, RBI hasn’t been able to gain much ground in any of the aforesaid areas. In fact, the rate hike has significantly lowered capital investments, stalled manufacturing activity, created infrastructural snags and also led to an exodus of foreign capital, thus breathing a sense of pessimism towards the globalized world. Growth is needed, owing to which public-private infrastructural investments are demanded, owing to which fiscal tightening instead of monetary tightening is required. Let’s take the case of subsidies in India:-

India’s non-planned expenditure fairly outpaces the planned and productive expenditure by consuming more than 60% of the budgeted expenditure. Subsidies account for more than 20% of this expenditure.

As for fuel subsidies; even though India has deregulated petrol prices, diesel and kerosene still cost the exchequer billions of dollars. Indian government considers diesel “poor man’s fuel” as it is used predominantly by farmers and by trucks for transportation of commodities.  Manufacturers and offices use diesel to fuel the generators that provide back-up electricity during frequent power cuts. But the widening gap between petrol and diesel prices has also prompted a surge in demand for diesel-fuelled cars, including sports utility vehicles, for the upper middle class, which has helped increase rising demand for diesel. Diesel prices could be differentially increased so as to reduce the overall burden. This means that prices could be first deregulated for luxury vehicles and telecom companies (the recent telecom scam cost the exchequer more than what these diesel subsidies cost them), and then gradually be increased through a piecemeal approach so as to prevent mass resentment from the people. The reduced deficit will help government absorb further increases in international crude oil prices and also facilitate investments in alternative renewable forms of energy. It shall also facilitate technological investments by upstream oil companies like ONGC and Oil India.

Moreover, as far as LPG and kerosene subsidies are concerned, a certain form of quantity rationing is required so as to ensure prudent usage of the same. Moreover it is important to check the diversion of these fuels towards adulteration, commercial purposes and resale in black markets. The absence of these checks is negating the whole purpose of these subsidies which are essentially meant for the “common man”.

Even for food subsidies, poor logistical and supply chain infrastructure is unduly leading to 40% wastage. This can only be curbed by necessary investments in technology and transportation.

Initiatives like the Unique Identity card project could facilitate direct cash transfer of subsidies, be it food or fuel or employment related guarantees. It shall go a long way in reducing the government deficit and that too without stoking inflation.

Another area of reform and growth is the power sector of the country. Still there are 300 million in the country without any access to electricity, not to mention the recent power crisis which put more than half of the population in complete darkness. It also underscored the fragility of the infrastructural foundation in our country which in turn is hurting our private sector’s international competitiveness. It inhibits growth by discouraging investments and impeding productivity improvements. Our power sector is in a decrepit state. India has a shortage of domestic coal as output at state-run Coal India , a near monopoly, has stagnated due to delayed environmental clearances, land acquisition troubles and little investment in advanced technologies.  Coal-based thermal plants are running at sub-optimal capacities mainly due to fuel shortages and transmission constraints. Government data shows there is an average delay of 15 months in the construction of new power plants. Tariffs haven't risen enough for years to cover costs for subsidies, corruption and inefficiency, nor has electricity theft been checked, forcing electricity distributors into losses as high as 40% in some states, while the country-wide average is 27%. These are the problems that are inhibiting growth in our country on one end and also causing inflationary pressures. If the government pulls the plugs on transmission losses (which amount to almost 40%) and expedites the development and commencement of new plants, it could considerably bring down the overall deficit without the need to raise tariffs and stoke inflation.

It is governance that is inhibiting growth and not inflation. Inflation and growth are not necessarily two distant edges of a spectrum which cannot have any middle ground promoting a win-win solution. India needs investments in areas of education and healthcare in addition to transportation and communication. Public Private Partnerships complemented by Foreign Direct Investments could go a long way in phasing out infrastructural impediments, and promote inflation free growth in the country. FDI in retail in slated to create more than a million jobs in the country, which in turn would promote greater consumption and also bring down the prices on account of robust logistical and warehousing investments. Similarly, educational investments will help leverage the demographic dividend of the country, which in turn shall have the “triple whammy” of improving labour productivity, stemming depravity (which costs billions of rupees to the exchequer) and reducing dependence on agriculture. The implementation of GST shall also facilitate growth while keeping inflation under check. In conclusion, it must be noted that, empirically, in the last decade, a GDP growth rate of eight per cent was always preceded by a low inflation rate (below five per cent). Thus, for India – an investment-led growth story – it is quite important to focus on a moderate to low inflation regime that is conducive for a longer-term high-growth phase.

This article has been authored by Harsh Gandhi from K.J.Somaiya Institute of Management Studies & Research.


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