Stimulus for fiscal incentives

It is hoped that the fiscal stimulus package just announced will help restore growth impulses in the economy.

S. Venkitaramanan

Fiscal inaction may be risky. In an uncharacteristically casual statement, Mr P. Chidambaram, who recently took over
as Home Minister, commented that the Indian economy is not facing a recession and that its estimated growth rate is a
respectable 7-8 per cent.

In his favour, unlike the US, we, in India, are not facing a recession defined in classic terms. However, there has been a
fall in growth for two quarters. Recession is stated to take place when the economy fails. Signs, however, portend a
sharp downturn in economic growth in India.

The recently published analysis of leading indicators by ICRIER analysts shows that the country’s growth rate may
even slip to the sub-7 per cent level in the coming quarters.

In a technically sophisticated analysis, some economists — Rajiv Kumar, M. Joseph and D. K. Singh — cautioned that
the growth, which is stymied by higher interest rates and fall in credit growth, could even be as low as 4 per cent in
2009-10.

The point to note here is that signs of decline in growth are already all around us — even if we ignore the effect of the
global slowdown.

Signs of degrowth

To cite an instance, recent news reports show that over 2,000 auto component manufacturing units in Jamshedpur and
nearby areas may face closure. Already, about 600 such units have closed down. This follows the decision of major
auto manufacturers, such as Tata Motors, to cut down production.

These units are usually small- and medium-scale industries, which depend on auto manufacturers for their orders. In
particular, the recent decision of Tata Motors’ commercial vehicle plant in Jamshedpur to shut down for eight days
came as a blow to for many of the ancillary units.

The same is the case with other commercial vehicle manufacturers, who have curtailed production. The production cuts
resorted to by auto manufacturers are a consequence of the economic slowdown caused by tight monetary policies,
including rise in interest rates and reduced credit flow from NBFCs. It is imperative that timely steps are taken to
correct these features of economic de-growth, which are mostly of our own making.

Vulnerable to global volatility

The authors mention that this decline is in addition to the fall in demand arising from the global slowdown, especially
in the American market. And domestic sectors such as textiles and software, with their export dependence, are the
worst hit.

We also have to contend with the fact that American auto majors are facing a sharp decline in demand due to falling
purchasing power. This, in turn, is reflected in loss of orders for some of our auto component manufacturers, whose
exports were linked to the US auto industry.

Incidentally, at the time of the US financial turmoil, many Indian economists tried to suggest that India, being less
export-dependent, was decoupled from the US. The theory of decoupling has been proved false and India remains
exposed to the prevailing volatility in global demand.

Revive demand
Not all is lost however. Much can be achieved by resorting to a a mix of fiscal and monetary measures to boost the
waning demand. This, is turn, would enable GDP to grow at 7-8 per cent, which is the least that we should aim at,
given our performance over the last five years.

The fear of some critics in regard to a fiscal stimulus is that India’s fiscal deficit, that of the Centre and the States
together, has already been running at around 10 per cent, as shown by the latest Budget. In addition, there are a number
of off-Budget items, such as oil bonds, which effectively increase the gross fiscal deficit/GDP ratio.

It is argued that, given these facts, any further fiscal expansion in the form of subsidies or tax concessions to ailing
industries will result in total fiscal unsustainability and a rise in the debt burden. There have been respectable voices
arguing that the “concord” between the RBI and the Government not to resort to unrestricted borrowing from the
central bank should be preserved.

While I respect the validity of this argument in general terms, the particular situation, where India is facing a dramatic
decline, on top of a global crisis, deserves to be treated differently. All methods should be used to enable the revival of
demand and employment. Manufacturing growth should be put on a sustainable footing.

Structural bottlenecks

It has been argued, in particular, that the defects lie in lack of infrastructure, such as roads and shortage of power. The
economy can surely benefit from paying more attention in clearing these structural bottlenecks. While I concede the
merit of the argument that structural and procedural bottlenecks exist and these should be rectified, the argument does
not preclude the case of fiscal incentives and need for action to boost demand.

The argument is made stronger by the fact that inflation has shown a declining trend in recent weeks. The fall in crude
oil price to as low as $40-45 for the Indian basket indicates that there is scope for an increase in monetary aggregates,
which may be implied by fiscal deficit expansion. A monetary contraction to fight inflation may not be justified in
these circumstances. The fact that oil prices have shown a sign of decrease may also enable the Government to restore
balance on the oil marketing companies’ front. The evolving political situation also dictates that it makes sense for the
Government to pass on the fall in the international crude oil price to the consumer.

Linking domestic prices to international crude oil prices will allow the Government to resort to increases in case of a
spike in global prices.

Suggestions have been made that the Government should resort to excise duty reduction to encourage manufacturers to
reduce prices. This makes sense. Indeed, it makes far better sense than the appeal of Mr Chidambaram to corporates to
reduce prices suo motu. If corporates have to protect their bottomlines, the Government must reduce exciserates.

Fiscal rectitude is in order for countries in normal times. But the current slowdown does justify fiscal stimulus. One
hopes the fiscal stimulus package just announced contains enough safeguards to ensure that inflationary concerns are
addressed.

It is hoped that the fiscal incentives package will restore the growth impulses in the Indian economy in the wake of the
global financial crisis.

(At the time of writing this article, only the outline of the fiscal stimulus package has
been announced. My remarks on the subject have to be seen in this context.)
Departure from inflation-targeting

With the Indian economy undergoing rapid structural changes since the 1990s, the notion of the
threshold rate of inflation must be revisited every five years.

A. Srinivas

The Reserve Bank of India’s moves to spur the economy through repeated cash reserve ratio and
repo rate cuts are all very well. But one wished it explain the current turbulence by providing
more theoretical insight and perspective, going beyond a short-term, policy-oriented approach.
For instance, the relationship between the financial sector and the ‘real’ economy is a burning
issue, yet the current global discourse is too focused on regulation and governance to capture
broader trends — and the RBI is no exception.

The central bank’s economy reviews should explore the current debates and academic literature,
so that people understand the backdrop against which it makes its observations. A theoretical
approach would also be useful while explaining the trade-off between inflation and growth.
Inflation targets would not seem as though they have been plucked out of thin air.

In this sense, the RBI’s Mid-Term Review of the annual Credit Policy for 2008-09 is a
disappointment. It does not explain why it considers 5 per cent inflation an acceptable target in
the short-term and 3 per cent in the medium-term, as opposed to any other set of figures. That
said, the review is categorical about pursuing a number of objectives, as opposed to targeting-
inflation alone, thereby differing from the approach spelt out in the Raghuram Rajan Committee
report.

MEASURING INFLATION

On inflation, the review says that it “it will be the Reserve Bank’s endeavour to bring down
inflation to a tolerable level of below 5 per cent at the earliest, while aiming for convergence with
the global average of around 3 per cent over the medium term”. Why these numbers? A threshold
rate of inflation is a level beyond which it becomes growth-retarding rather than beneficial to
output and employment.

The Sukhamoy Chakroborty committee in 1985 had pegged the threshold rate of inflation at 4 per
cent. A decade later, the then RBI Governor, Dr C. Rangarajan, put the level at around 6 per cent.
What is the threshold level of inflation at present is anyone’s guess, as the RBI has not examined
this issue in recent years. With the Indian economy undergoing rapid structural changes since the
1990s, the notion of the threshold rate of inflation must be revisited every five years.

This should be accompanied by sharper indices to measure price rise. The wholesale price index
should not only represent all the goods and services available in the country, but also ensure that
their prices are accurately recorded through sampling methods that are revised from time to time.

Similarly, core inflation, consisting of non-volatile elements, should be separated from headline
inflation, which consists of food and energy prices that are prone to short-term fluctuations. To
get a fix on inflation, the RBI and the North Block should be clear on a separate threshold level
for core and headline inflation. An inflation figure for 1,224 disparate goods and services, against
435 at present, would not mean much.
MULTIPLE OBJECTIVES

Should the RBI only target inflation or also seek to control asset prices before they turn into
bubbles? The former Governor, Dr Y. V. Reddy, indicated his preference for a “multi-
disciplinary approach”. Under him, the RBI contained a property bubble by increasing the risk
weightage for real-estate lending in 2006.

The Mid-Term Review reflects a continuation of this approach, saying: “The task of monetary
management has always centred around managing a judicious balance between price stability,
sustaining the growth momentum and maintaining financial stability…The global financial
turmoil has, however, reinforced the importance of putting special emphasis on preserving
financial stability.”

The Raghuram Rajan Committee on financial sector reforms has advocated inflation-targeting, to
the virtual exclusion of other objectives. In the wake of the financial crisis, this approach has
come under scrutiny in academic and policymaking circles in the US and Europe. The RBI’s
position marks a departure from the Greenspan-Bernanke line.

Attacking the inflation-targeting approach, Paul De Grauwe of the University of Leuven and
CEPR says in a paper, “Banks were heavily implicated both in the development of the bubble in
the housing markets and in its subsequent crash...Some may wish that central banks would
abstain from supplying this insurance. Economic theory, however, tells us that central banks
should intervene to provide liquidity if the liquidity crisis risks disrupting the payments system,
hurting many innocent bystanders... It is not reasonable for a central bank to argue that asset
bubbles and crashes should not be a source of concern... when it knows that the bubble will have
large implications for its future balance sheet...” He disagrees with the Greenspan school, which
believes that “the macroeconomic consequences of bubbles and crashes are limited as long as
central banks keep inflation on track” and that “the central bank should not target (or try to
influence) asset prices”.

The fact that a lot of liquidity creation in relation to the housing bubbles has occurred outside the
banking system, while also implicating banks, does not speak favourably of a hands-off approach
to asset prices, the paper argues.

A contrary view comes from Katrin Assenmacher-Wesche and Stefan Gerlach of the Swiss
National Bank and Johann Wolfgang Goethe University, respectively. In a paper, they argue, “In
addition to the fact that the central bank should form a view of whether a particular asset price
increase is dangerous or not, it requires monetary policy to have predictable effects on asset
prices... The size of interest-rate movements required to prevent a bubble from developing must
not be so large as to cause output and inflation to drop substantially below the central bank’s
objectives for them.”

Analysing the responses of property and equity prices to monetary policy shocks in 17 OECD
countries between 1986 and 2006, they discovered that a 100 basis points’ increase in interest
rates leads to 2.6 per cent drop in real property prices over 16 quarters. Real GDP falls by 0.8 per
cent over 16 quarters, or a third of property prices. Equity prices fall immediately by 2 per cent,
but after 16 quarters are just 0.5 per cent below their initial level.

The paper says that to target asset prices, “the effects of monetary policy on different asset prices
must occur at about the same speed...”
Monetary tools

Since property and equity prices react at different speeds, the authors feel that central banks
cannot stabilise both. “The idea of using interest rate policy to forestall asset prices bubbles is not
practicable”, they conclude, adding that “monetary policy is too blunt an instrument to be used to
target asset prices”. This view is close to that of Federal Reserve Chairman, Mr Ben Bernanke.

The RBI should come out with a position paper on the relationship between the ‘real’ and
‘money’ economy, indicating in the process whether asset prices should be monitored as a matter
of policy.

At the end of 2005, total financial assets were 3.7 times world gross domestic product. Market
capitalisation in India is 150 per cent of GDP, higher than US (128.8 per cent), Japan (104.4 per
cent), China (137.3 per cent) and South Korea (116.2 per cent).

While the financial sector helps channelise savings towards investments, generates liquidity and
reduces the cost of credit, it can be carried away by its own dynamic, undermining stability in the
real economy. What is the threshold level beyond which the growth of financial assets should be
considered dangerous, leading to a bubble? There seem to be no yardsticks to guide policy in
these areas.

The RBI’s policy statements should reflect the changing global discourse. When the Finance
Minister or the RBI Governor expresses faith in financial sector reforms, he should explain what
that means in the current scenario. The people have a right to know.

Date:07/11/2008 URL:
http://www.thehindubusinessline.com/2008/11/07/stories/2008110750130800.ht
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Drowning in liquidity
S. S. TARAPORE

Injecting large doses of liquidity would only result in hair-curling inflation in 12-15
months. The central issue that needs to be addressed is whether the Indian monetary
policy response to the global meltdown was appropriate, says S. S. TARAPORE.

The global financial meltdown is unprecedented and the contagion has spread like
wild fire. The central issue we need to address is whether the Indian monetary policy
response was appropriate. The major industrial countries have worked in concert and
pumped in large liquidity into the system and we, in India, have done likewise. What
was ostensibly a liquidity problem is turning into a solvency problem.

We need to look at the path-breaking work, in 1926, by a Russian economist,

Nickolai Kondratieff entitled Long Waves in Economic Life. The major premise was
that capitalist economies experience long wave cycles of boom and bust and that
each cycle lasts 50-60 years.

This work was unfortunately considered as a veiled attack on Stalin’s total

collectivisation of agriculture and, in 1938, he was given the death penalty. Today’s
economists and policymakers would do well to carefully imbibe Kondratieff’s
fundamental work.

According to Kondratieff, there are four phases of the long wave cycle: Inflationary
growth, stagflation/recession, deflationary growth or a plateau and, finally,
depression. Furthermore, Kondratieff held the view that in each phase of the cycle,
policy reactions are tempered by knowledge and experience and the endeavour is to
attain a higher peak.

No room for complacency

Policymakers and opinion makers, the world over, would make us believe that all
this is history and that we now have sound systems in place to ward off a long
depression. The problems which have become visible may be only the tip of the
iceberg and the world economy could well be headed to a depression.

In India, we are being assured that as we do not have the complex financial products,
which have been the bane of industrial countries, we are protected from the
international turmoil. Our systems could be as strong as or as fragile as global
systems and, hence, there is no room for complacency. Furthermore, we could be at
a different inflexion point of the cycle that could be deceptive. Still, the Indian
situation is of relatively high growth of around 7.5 per cent in 2008-09 and 6-6.5 per
cent in 2009-10. What is worrisome is that while, in recent weeks, inflation has
somewhat abated, it is intolerable as it is still in double-digits. In such a situation, a
large and sudden injection of liquidity is a cause of anxiety.

Monetary management

To be effective, monetary policy has to recognise the inevitability of real sector

cycles. During the boom, there is a general euphoria and the central bank is egged on
to lower interest rates and to flood the system with created money. As the party gets
uncontrollably merry, the central bank has to take away the punch bowl but, by then,
the downturn of the cycle would have started. The art of good monetary
management is to undertake monetary tightening during the upturn of the cycle, well
before the upper turning point is reached.

This is precisely what the former RBI Governor, Dr Y. V. Reddy, tried to do all
along since 2004. Admittedly, monetary policy cannot be formulated in a vacuum
but has to be consistent with the overall direction of economic policy. Dr Reddy’s
parting remarks were telling when he said that had he had his way he would have
tightened further. Dr Reddy was pilloried and burnt at the stakes but the merits of his
monetary policy are slowly being recognised. His “Beatification” and subsequent
“Canonisation” would take place only after the definitive history of the recent period
is written.

In the major industrial countries and in a number of emerging market economies,

large liquidity has been pumped in. Likewise, in India, the Reserve Bank of India
(RBI) has recently pumped in at least Rs 300,000 crore, approximately equivalent to
7.5 per cent of banks’ deposit liabilities.

The repo rate has been reduced from 9 per cent to 7.5 per cent. The old central
banking dictum on interest rates was “up by ones” and “down by halves” but the
recent Indian experience appears to be “up by quarters” and “down by ones”.

Credit extension

Apart from a liquidity shortage, resulting in a cessation of credit, the situation in

India has been one of over-extension of credit relative to the resources of the
banking system. The year-on-year incremental credit-deposit ratio is a staggering 96
per cent. No wonder the banks have no resources to lend. After three years of
unbridled 30 per cent per annum credit expansion, there is bound to be a slowdown.

The problem in India regarding credit expansion is structural and not shortage of
liquidity. The former RBI Governor, late Dr I. G. Patel, would often tell the banks
“do not lend the money you do not have.”

Rather than suddenly pumping in over Rs 300,000 crore of liquidity into the system
within a few weeks, it would have been preferable to calibrate the release.
Furthermore, the sharp reduction in the repo rate has made it even more out of kilter
with other rates in the system. To be effective, the RBI’s policy signalling rate
should be a penal rate and not a subvention.

The history of foreign institutional investments the world over is that large inflows
are followed by outflows and, as such, the fall in the forex reserves was predictable.
Admittedly, when forex reserves fall precipitously, the RBI should step in and
prevent a total dislocation in the credit system by releasing some domestic liquidity.

Illustratively, if Rs 100 is withdrawn as a result of a forex reserve loss, the RBI

should restore, say, only Rs 75. Excessive replacement of the reduction in liquidity
will only reinforce the subsequent forex reserve loss.

Over time, the RBI’s exchange rate management has been par excellence. One
should not look at nominal exchange rates in relation to the US dollar but monitor
the Real Effective Exchange Rate (REER). In the recent period, the RBI has allowed
only a gentle depreciation of the REER, which is only appropriate. Rather than
opening up external commercial borrowings, the authorities should have considered:

Increasing the ceiling on FII investment in the government securities market; and

Non-Resident External Rupee Accounts (NRERA) should have been made free from
reserve requirements and deposit rate control on such deposits should also have
been lifted.

This relaxation should not apply to Foreign Currency Non-Resident (Banks)

Deposits; in fact, this scheme, which was a creature of the 1990-91 crisis, should be
abolished.

The world over, there has been too much merry-making. May be the time has come
to face up to a long, dark winter of depression.

In India, measures to alleviate the pain will only result in greater pain. Injecting
large doses of liquidity would only result in a hair-curling inflation in 12-15 months.
We should not look for magical solutions. The role of the fisc and external sector
management deserve separate examination.
Calibrating the inflation meter

People’s income has changed, and so has their consumption pattern. This recognition is essential
as we move towards an improved Consumer Price Index.

Lakshmi Kumar

The debate over WPI (wholesale price index) vs. CPI (consumer price index) has grown in the
past few months with inflation creeping up week after week before showing a downward trend.

The WPI is used as a measure of inflation in India, although it has been argued time and again
that the CPI is a better indicator. The lack of adequate machinery to measure the CPI sees us
continuing with the WPI, which on closer examination shows tha t it does not include a lot of
items consumed in India today.

The differences

The WPI is an indicator of the movement in wholesale prices of 435 commodities. It is the only
price index available weekly, with the shortest time lag of two weeks, making it widely used in
business and industry circles as well as the Government. The base year of the WPI series is 1993-
94.

On the other hand, the CPI for industrial workers — CPI (IW) — is constructed on a monthly
basis, with a lag of one month. CPI measures changes in the retail prices of goods and services
covering 260 items from 70 centres. The base year for the CPI (IW) is 1982.

The WPI and CPI (IW) series differ significantly in terms of weights. This implies that the degree
of importance given to specific commodity groups is not the same in the two series. While food
gets the maximum weight of 57 per cent in the CPI (IW) series, it gets only 27 per cent in the
WPI series. The CPI (IW) series is therefore more sensitive to changes in food prices.

The fuel group, on the other hand, gets a much higher weight in the WPI series (14.23) compared
to the CPI (IW) series (6.28).

International price movements of crude oil would therefore have a greater bearing on the WPI
series in terms of direct impact. One major subgroup in the CPI (IW) series is the miscellaneous
group which includes services such as transport, education, health and so on. Services, a major
contributor to the GDP, however does not get reflected in the WPI series.

Therefore, the differences in the inflation rate between the two series could also be on account of
price movement in the services sector, which gets captured in the CPI (IW).

Getting it right
While it is obvious that the CPI is a better indicator of inflation than WPI, one wonders whether
the constituents of CPI reflect the consumption basket of the present generation.

The CPI composition has not changed since 1988, while the people’s consumption basket has.
For instance, there were no mobile phones in 1988. Today, mobiles phones are commonly used
even in rural areas.

Consequently, it might be more useful to look at trends in the Private Final Consumption
Expenditure (PFCE). A comparison (see table) shows there are significant differences in the
items and their weights between the constituents of CPI and PFCE. The latter reflects the changes
in the consumption basket, as it also includes FMCG products. However, more important is the
differences in the weights assigned to the different categories.

Food and related items seem to have lesser weight and have been reducing (51 per cent to 40 per
cent) since 1999, but remain as high as 60 per cent in the CPI. Obviously the weight assigned is
too high. When we compare the two series we realise that the weight assigned to food has come
down but the weight for other items need to increase in line with the changing consumption
patterns.

With higher incomes it is but natural to consume a variety of goods, and though food
consumption may go up, its relative importance in a family’s budget has come down.

Another interesting fact about the table is that the miscellaneous category under the CPI has a
weight of about 16 per cent while it is about 44 per cent in the PFCE. Medical care, education,
transport and communication have been high consumption categories in the past few years and,
naturally, expenditure on these has gone up.
Also, FMCGs have been recognised in PFCE as an important component of a family’s
expenditure, whereas CPI does not recognise it as a separate category.

Without doubt, the PFCE appears to be a better reflection of our times, and while we move
towards CPI from WPI it would be useful to use PFCE to assign weights to the different
categories.

People’s income has changed, and so has their consumption pattern. This recognition is essential
as we move towards an improved CPI. Additionally, these weights can be changed each year by
gathering information on the present final consumption expenditure.