Growth-inflation balance is delicately positioned and requires surgery rather than more Botox, rues Rajeev Malik
Dear Mr Jaitley,
Hearty congratulations to Narendra Modi and you on an electoral victory that will be savoured for a long time.
To say the very least, Mr Modi’s campaign has rewritten the script of India’s national elections.
It is time to do the same for India’s economy, the greatest underachiever in Asia.
It was a particularly low point in India’s unforgivably clumsy economic management that prompted me to throw up my hands and request for unique external assistance (“Seeking divine intervention”, Business Standard, May 10, 2012).
Time will tell if Mr Modi and you are the long-lasting correct answers, but your government surely has the mandate, ability and the intellectual firepower to be the much-desired and long-overdue instrument of change.
It is not my intention to list, again, the nitty-gritty of what needs to be fixed and how to go about it.
These have been well known for two to three years, and you are probably overwhelmed by inputs from people better positioned than a social zero like me.
I did take the liberty of offering my two paise in two previous columns in this newspaper, including one addressed to the prospective prime minister (“Hurry slowly”, April 1, and “Hit the ground running”, May 6).
My scope here is more limited: I want to emphasise the generally ignored issue of consistency in India’s macroeconomic management.
Everyone can become a good analyst ex post, but policymaking is all about solving problems in real time without creating new ones. This, however, is often not the case in India.
The idiosyncratic aspect of India’s macroeconomic challenge is the stubbornly high retail -- especially core -- inflation, despite the collapse in economic growth.
This issue needs to be better understood and appreciated for sustained non-inflationary growth acceleration. And it will warrant more than just bringing back to life the stuck projects and/or releasing more foodgrain into the market to check food inflation.
The inflation demon in recent years was ignored in favour of a pro-growth strategy.
To be sure, the inflation debate often gave the impression of the government’s -- and the private sector’s -- desire for higher growth despite high inflation.
Therein is the most serious macroeconomic oversight: it is impossible to have sustained growth acceleration when inflation is high or rising.
Almost all analyses of India’s inflation problem ignore its endogenous drivers.
Analysts engage in mental gymnastics, often behaving more like accountants than macroeconomists.
In the process, the feedback loops from, say, fiscal misdemeanours and the chronic demand-supply imbalances in some sectors are often ignored.
For six consecutive years, India’s retail inflation has been above real gross domestic product (GDP) growth.
Inflationary pressures have been a complex mix of demand- and supply-side factors, cover food and non-food categories, and are structural and cyclical in nature.
Global commodity prices too have been a key driver of inflationary pressures, which were exacerbated earlier by above-trend GDP growth, a populist fiscal agenda and sharply higher prices for farmers to increase food production.
The persistence of high inflation has been because of the changing underlying drivers, their faulty diagnosis by policymakers, and delayed and inadequate policy response.
The early cyclical inflationary pressures were soon complemented with structural pressures.
The chronic neglect of consumer price index inflation in favour of wholesale price index inflation further complicated matters as real interest rates were low, rather than high, as was often perceived. Last year’s shift to CPI inflation yardstick by the Reserve Bank of India for setting policy interest rates was a key step in the right direction.
The RBI’s tight money policy has often been blamed for the growth debacle and businesses have favoured lower interest rates from the central bank, ignoring the uncomfortably high inflation.
The logic was that raising interest rates won’t affect food inflation, and therefore the RBI’s tight monetary regime is only worsening the growth deceleration.
Another shade of this debate to get the central bank to cut interest rates was that lower borrowing costs will improve investment and hence the supply side of the economy.
This will eventually lower inflation. Both arguments are misguided, in my view.
The problem with the first argument is that it only selectively looks at lending rates while conveniently ignoring that the right level of interest rate in any economy is the one that balances depositors and borrowers.
Until recently, monetary policy in India was viewed mainly from the borrowers’ perspective.
This view irresponsibly ignored adequate inflation-adjusted returns to depositors.
Indians’ thirst for gold and the rupee debacle were both affected by this neglect of inflation-adjusted return to depositors.
The second argument, even as it ignores the fate of depositors, overlooks the near-term pressure on aggregate demand when core inflation is already uncomfortably high.
Yes, premature cutting of interest rates could boost investment activity, which could lower inflation in, say, a couple of years’ time.
But what about the management of the business cycle between now and then?
A key macroeconomic dimension of reviving growth and lowering inflation has to be fiscal discipline.
You must announce a credible plan for good-quality fiscal correction to facilitate investment-led growth.
A wider fiscal deficit, no matter how tempting politically or to pacify industry, is not the need of the hour.
That, of course, doesn’t mean that you should not push for higher capital spending.
However, it is important to ensure that that doesn’t result in slippage on the fiscal deficit, and also rein in the subsidy bill.
Even with real growth at a dismal 4.6 per cent year on year, the loan-deposit ratio is at an elevated 77 per cent.
This is because of subdued deposit mobilisation. With CPI core inflation still uncomfortably high and loanable funds with the domestic banking system -- which is already nursing asset quality challenges -- stretched, a pickup in economic growth in the near term is more delicately positioned than is acknowledged.
In fact, a key risk that will need to be managed is that a cowboy approach towards growth revival will potentially worsen core inflation dynamics, prompting the RBI to tighten again.
A long-lasting solution for low and stable inflation is still elusive.
This solution, which has to cover more than just food inflation, lies with the government rather than with the RBI.
As you craft the upcoming Budget, kindly set a higher bar for fiscal transparency and discipline in your new ministerial inning.
And please avoid the use of Botox, since a sustained growth revival needs economic surgery, not another cosmetic job.
Rajeev Malik is senior economist at CLSA, Singapore. These views are personal.
