The Hindu Business Line : Inflation and growth

For an economy with large unemployed resources, running a persistent current account surplus and, at the same time, raising interest rates to dampen aggregate demand and slow down economic activity, may call for simple and cautious policy solutions, which will not be in line with current aspirations. Instead, it may be better to bet on growth and use the opportunity to lower costs and rationalise the tax structure, say Rajiv Kumar and Devika Mehndiratta.

INFLATION reached a 40-month high the week ending August 28, touching 8.3 per cent. It has since declined to 7.8 per cent, but both global and domestic conditions point to a continued upward trend in inflation for the coming period.

An argument often made is that the Wholesale Price Index (WPI, Table 1) overstates inflation, especially when compared to the Consumer Price Index (CPI). While there is no denying that CPI shows a lower increase in inflation, there is no systematic trend over the years in their divergence and even the CPI has shown an unmistakable upward trend in recent months. Ignoring these trends would, therefore, be unwarranted. However, it would be useful to focus more on CPI to try and weaken inflationary expectations. Reports that a producers' price index is in the making, if true, are welcome and long overdue.

The urgency for anti-inflationary measure becomes stronger once we recognise that it reflect a cyclical upswing in global growth and inflationary conditions in both the developed and developing economies. The US inflation rose to 2.7 per cent at the end of August from less than 2 per cent in the first quarter.

China recorded an inflation rate of 5.3 per cent in August, the highest since February 1997 and, in neighbouring Pakistan, inflation climbed to 9.3 per cent in July from a sedate 6 per cent in 2004 first half. Domestic inflationary expectations are likely to be strengthened because of these international trends. An appropriate policy response is required to weaken them before they take hold. Action is also necessary because both on international and domestic grounds, the current spike in inflation does not appear to be transitory in nature. Even if it shows a downward blip in some weeks on account of inflation being higher in the corresponding previous period (the base effect) its trend is unambiguously upward for coming months. At the same time, it is important to ensure that anti-inflationary measures do not dampen the current growth momentum in the industrial and services sectors.

An upward trend in inflation, generally seen as reflecting excess demand in the system, provokes a policy-induced hike in interest rates designed to dampen demand and cool down economic activity. If done incrementally and early enough, it helps to bring down inflation and yet not affect capital formation. In the current Indian situation, some demand-pull pressures are visible as a result of six quarters of strong industrial growth and strong increase in housing credits. The latest data on GDP growth of 7.4 per cent in the first quarter of 2004-5 would further strengthen calls for demand restraints in the light of emerging capacity constraints.

India's enormous pool of unemployed labour can be absorbed only by sustained and high growth in industry and services sectors. There is also the need to urgently build rural infrastructure and raise agriculture productivity. Therefore, at this stage, it may be premature and, indeed, counterproductive to raise interest rates.

It will weaken inflationary expectations but with rising costs and no immediate respite from global commodity price increases in sight, this could as well result in an avoidable stagflation.

The most important of these cost-push factors is, of course, the rise in international oil prices. Oil prices will come down from the $50 level. But the sustained China demand; the cyclical economic upswing in OECD economies; and the continued uncertainty in West Asia, are likely to keep oil prices around $45 at least till spring of 2005. This is reconfirmed by the trend in oil futures (Table 2).

Higher oil prices, given their economy-wide impact, are akin to an interest rate increase. Their contractionary impact on the economy can be unduly exaggerated by raising interest rates whose economy-wide impact cannot all be foreseen.

It may be prudent to avoid taking recourse just yet to demand-dampening and liquidity-absorbing measures other than the raise the cash reserve ratio, which the RBI did recently. This move has tightened money market conditions, as reflected in the rise in the overnight call rates.

So, policy measures to combat inflation will have to primarily target cost-push factors. The main culprits for this cost-push inflation have been basic metals and alloys, crude oil and petroleum products, and manufactured food products. The Government has rightly reduced import duties on the above products as also on edible oils.

With crude oil prices now crossing the $50 per barrel mark and commodity prices not showing any weakening tendencies, additional measures are required.

One of this could be to reduce domestic taxes on petroleum products while, at the same time, moving to a market-driven pricing regime for petroleum products. Total taxes on petroleum products in 2003 added up to a significant 54 per cent in 2003 of the final consumer price. This has risen from about 30 per cent in 1993.

Most European countries and Japan also have a similar tax structure on oil. But it is noteworthy that both the US (25 per cent) and China (VAT of 17 per cent) have kept their taxes on petroleum products at significantly lower levels. A reduction in petroleum taxes will absorb the current price increase, have a positive cascading impact on economic growth and help sustain the growth momentum.

But there is a major caveat. Such a relatively cheaper hydrocarbon policy must be accompanied by measures that lead to improvement in energy efficiency. India's energy-to-GDP coefficient is nearly six times higher than the US' and almost ten times higher than Japan's. An energy-deficit economy like India can hardly afford to be so profligate in its energy use.

Reduction in taxes on petroleum products can be done only if viable on fiscal grounds and does not lead to a worsening of the revenue and fiscal deficit to levels incompatible with the fiscal responsibility and budget management act. However, there is reportedly a more than 40 per cent increase in direct tax collection during the first four months of the current financial year. This is attributed to the implementation of the Tax Identification Number (TIN) scheme and points to the possibility of revenue-led reduction in the fiscal deficit. This revenue buoyancy can be further reinforced by acting boldly on the recommendations of the FRBM Task Force on rationalising the indirect tax structure and introducing a unified goods and services tax after effectively implementing a destination based VAT in the States.

The policy choice is clear, though admittedly difficult. Should interest rates be raised at this stage to dampen aggregate demand and, in turn, weaken inflationary expectations? Or should the opportunity be used to implement further fiscal reforms; rationalise indirect taxes; improve compliance of direct taxes and expand their coverage; and simultaneously increase public expenditure for achieving inclusive growth? The latter would be the better option.

Along with a reduction in petroleum taxes, some other measures can also be taken. These will inter alia include a cut in import duties on naphtha, which has multiple uses as an intermediate input and has been excluded from duty cuts so far; greater imports of raw materials and intermediate goods by using the large foreign exchange reserves; urgently addressing capacity constraints in ports and transport; and, as was done in 1993, announce and undertake necessary imports of essential consumer goods, including food products and release larger volumes of grains from government stocks to quash speculative behaviour.

In addition to the cost-reduction efforts, two other measures, both related to the external sector, can also be taken. First, the RBI can ensure foreign exchange stability to avoid importing inflation over and above the increase in international commodity prices. Second, the suggestion made by the Prime Minister, Dr Manmohan Singh, to use the burgeoning foreign exchange reserves to import necessary equipment and expand infrastructure capacity needs to be implemented expeditiously.

For an economy with large unemployed resources, running a persistent current account surplus and, at the same time, raising interest rates to dampen aggregate demand and slow down economic activity, may display a preference for simple and cautious policy solutions. This will, however, not be in line with current aspirations. Instead, it may be better to bet on growth and use the opportunity to lower costs in the economy and rationalise the tax structure, steps that will make the Indian industry more globally competitive.

(Rajiv Kumar is Chief Economist and Devika Mehndiratta is Economist with the Confederation of Indian Industries. Their views are personal.)