The Hindu Business Line : The `overheating' debate

The RBI should reconcile its policy objectives of controlling inflationary expectations with the perceptions of the Government, which demands an increased focus on growth. Only on the resolution of these differences will India be able to sustain its growth rate. The overheating debate should not be allowed to overcool the prospects of economic growth with stability, says S. VENKITARAMANAN.

There has been a public debate between the Finance Ministry and the RBI about whether the economy is showing signs of overheating. This debate is important because if the RBI is right that there is overheating, it is fully justified in tightening credit, by increasing rates of interest and introducing further provisioning restrictions. On the other hand, if the Government is right that the case of overheating is overstated, the RBI should hold its hand. It is important to note that the Government has decided to lay bare its differences with the central bank instead of trying to resolve them by mutual discussion.

The dissent appeared as part of the Mid-Year Review of the Economy, which fulfils the statutory requirements imposed by the FRBM (Fiscal Responsibility and Budget Management Act). The review incorporates a progress report on various fiscal deficit targets that the Government has to achieve under the Act.

First, let me refer to what the Review says on the FRBM targets. Despite improvements on the revenue collection front, some of the mid-year benchmarks prescribed by the FRBM Act have not been met. Especially in regard to non-debt receipts, which should have reached a figure not less than 40 per cent of the budget estimate in the first half of 2006, the Government has achieved only 39.9 per cent. This is, however, only marginally less than the target.

The fiscal deficit during the first half of the year should not have been more than 45 per cent, whereas in the 2006-07 financial, it reached 58.2 per cent so far. The Government has to do more to achieve the targets in the remaining months of the fiscal. In terms of revenue deficit, the record is dismal. Against the target of not more than 45 per cent the Government had touched 81.8 per cent of the budgeted deficit.

Upbeat on Targets

Maybe, the targets laid down by the FRBM have not adequately taken into account the pattern of expenditure in the Government departments and the fact that there is an increased frenzy of collection and expenditure towards the last few months of the year. The Finance Ministry's review, however, points out that better cash management and the frontloading of expenditure have been achieved in 2006-07 compared to last year.

The Review seems upbeat about the possibility of achieving he fiscal deficit targets laid down in the Budget. It seems quite likely, considering that advance corporate tax collections have been quite hefty — nearly 50-70 per cent better last year. This is partly a reflection of the robust corporate profits and growing national income. The Finance Minister seems to be enjoying a streak of good luck, in that his estimate of fiscal performance seems realisable.

I had remarked last week on the fact that GDP growth estimates for the first half of the year are nearly 9 per cent. There is every expectation that the pace will be sustained for the remaining part of the year. The Achilles' heel of the economy is, however, agriculture and infrastructure. One has to await the Budget to see what the Finance Minister has in mind in respect of these sectors.

It is in this context of the need for higher outlays on both these sectors that the debate on over-heating gains importance. Let us recall how the RBI has defined overheating in its macroeconomic policy statement of October 31, 2006:

"An overheating economy is one which is growing rapidly and its productive capacity cannot keep up with resultant demand pressure. Emergence of inflationary pressure is usually seen as the first indication of overheating. In this context, the policy-makers keenly analyse the behaviour of the output gap. The excess of the current output is over potential or full capacity output".

Differing Views

Judging how an economy is close to operating to full capacity is crucial. The RBI admits that globally it is increasingly difficult to identify symptoms of overheating and blurring of relationship between output gap and inflation. Maybe, the RBI is referring to the fact that additional supplies are possible from various external sources, as is happening in the United States and partly in India. Partly also, there is the complication that the economy is undergoing structural transformation.

The RBI's argument rests primarily on the fact that the economy is growing fast and it cannot meet its demands for goods, in general, with the output it produces. This gap reflects itself in inflationary pressure. The remedy that the RBI suggests for overheating is contraction of credit which, in turn, results in contraction of growth. The Government's response is that the signs of overheating do not exist at the moment, and that there have been other economies, such as China's, where growth is continued at a high rate in long period of time.

This has been so in Japan. Inflationary expectations have also to be managed by supply-side actions, such as increasing production and productivity and lower prices, if necessary, by tax actions.

Obviously, the ministerial review points out that the attack should be rather on inflationary expectations rather than the inflation in the past. In fairness to the RBI, it must be admitted that inflationary expectations are themselves built on the basis of inflation in the past and the RBI may, however, be right in assessing that inflationary expectations are high precisely in view of high inflation.

The debate will be resolved partly by unfolding events in the oil scenario, thanks to the declining crude prices. The better monsoons also might help to the extent to which the harvests are expected to be good. Price pressures may ease.

Real Concerns

In this context, one has to refer to the breezy manner in which the Ministry brushes off the RBI's concerns about the current account deficit, saying it is being financed by non-debt inflows. But the concern is real and there is no point in citing the planners as supportive of the deficit. Action is needed to contain the deficit to incentivise foreign capital inflows, which are critical.

There is an obvious conflict between the Government's growth expectations and the RBI's inflation management. The RBI should reconcile its policy with the perceptions of the Government, which demands an increased focus on growth. The debate on overheating should not be allowed to get out of hand. The Government should have discussions with the RBI to arrive at the right policy frame for credit growth, especially to agriculture and small and medium industries. This has to be reconciled with the policy objectives of the RBI to control inflationary expectations.

Only on the successful resolution of these differences will India be able to sustain its growth rate, which has fortunately been robust. The overheating debate should not be allowed to overcool the prospects of economic growth with stability.