The Hindu Business Line : <roman1>EAC update: Outlook on growth and inflation </roman1>

Curtailing money supply growth has to be an integral part of the recommended policy package. Growth requires financing, but inflation management requires containing money supply. How are we to reconcile these opposing requirements?

Recently, there has been a feast of economic updates, starting from the RBI Governor, Dr Y.V. Reddy's macro-economic policy statement of October 31, 2006, and the Finance Ministry's mid-year review of the economy. This flurry of forecasts now reaches its climax with the Economic Advisory Council (EAC) to the Prime Minister presenting its update of the outlook, particularly on Balance of Payments, Central Government finances and inflation.

The EAC, headed by the redoubtable Dr C. Rangarajan — one of our eminent economists — is, indeed, a good appetiser for the Economic Survey, which will be timed just before the Budget. On the current account deficit, the EAC observes that while the current account deficit numbers for the first half of the year are reported to be 2.5 per cent of GDP, they require revision in the light of past experience. Taking such reviews into account, the EAC expects the current account deficit to be about 1.5 per cent of GDP. Such frequent substantial downward revisions, which have characterised the data in recent years, admittedly erode the credibility of our data.

Foreign Direct Investment, in the EAC's view a more desirable form of capital, has increased in the recent period. Net foreign direct investment this year will, for the first time in several years, exceed portfolio capital flows. Net FDI flows will be around $9 billion, up from $4.7 billion last year. This comprises inbound FDI of around $12 billion, offset by an outward FDI of $3 billion. It is worth reflecting that inward FDI flows are still relatively small compared to the $50-billion-plus figure recorded by China, year after year.

The EAC comments that the measure of global integration of our economy — the ratio of total trade to GDP — will be 35.9 per cent this year, up from 32.8 per cent last year. If we include software exports — as is inevitable — the figure goes up to 39 per cent. This is, indeed, commendable, although the higher the measure of inflation, the more vulnerable India is to global trends, especially economic cycles in the US, Europe and Japan. That is the price we have to pay for being a member of an integrated world trade.

The details of the data on BoP given by the EAC are instructive. They raise important issues as to the sustainability of our growth process. The figures disclose that our balance of trade in the full year 2006-07 will be a massive negative of $65 billion. This is expected to go up to 7.3 per cent of GDP in the current year. The current account deficit is, however, lower, in view of the offsetting impact of invisibles. The net invisible income, inclusive of software and remittances, comes to nearly $54 billion. Deducting net investment income, primarily royalty and dividend payments, the net invisible contribution is $52.5 billion, bringing the current account deficit this year to around $13.4 billion. The Table brings out the basic features of the EAC estimates.

Building up liabilities

Whereas the current account deficit of $5.4 billion in 2004-05 was financed by foreign direct investment of $3.2 billion and from portfolio capital of $8.9 billion in 2004-05 together with loans of $14.7 billion, the gap of -$13.4 billion in the current year is expected to be financed by net FDI of $9.0 billion and portfolio capital of $7.6 billion plus loans of $14 billion and banking capital of $4 billion.

While the figures of current account deficit are at a low level of 1.5 per cent of GDP, its absolute levels are high and their financing build-up liabilities — both equity and debt. This is a far cry from China's experience, where the build-up is essentially of outward investments. The BoP figures, impressive on the surface, mark a definite vulnerability. We are spending on imports much more than what we are earning through exports. Result — we are building up liabilities to the rest of the world. While current account deficit as a ratio to GDP may be on EAC's estimate only 1.5 per cent, it is bound to go up if we continue to import more crude oil, more steel and more food-grains. The answer lies in increasing our exports of both goods and services. This calls for appropriate policies in respect of exchange rate policies and an enabling environment.

Turning to the government finances, the EAC report reiterates some of the points presented in the Finance Ministry's mid-year review. The growth of Central taxes has been impressive, particularly on the Direct Tax front. However, the quality of expenditure is not in the desirable direction, says the EAC. Much more is being spent on non-Plan revenue items than on Plan capital. The EAC report points out that much more needs to be done in stressing the right type of expenditure management. More investment and less subsidies seem to be the mantra.

Inflation prospects

The views of the EAC on inflation prospects for the current year are of interest. It points out that the WPI-based inflation may well reach 6 per cent by the end of this year. Part of the reason is the rise in price of food-grains and primary products. Expectations of high prices may themselves influence higher sowings of wheat, which may lead to higher crop prospects and, incidentally, release price pressures.

The EAC also points out that inflation numbers will depend very much on the way the crop prospects shape up. Inflation, stresses the EAC, is basically a monetary phenomenon. This view does not fit in entirely with the underlying element of the EAC's view, which stresses greatly on crop prospects and the supply side policy measures. While inflation is essentially a monetary phenomenon, these policy measures do have relevance. Prof Rangarajan is too sophisticated an economist not to have thought of nuanced arguments to counter this possible line of attack on monetarist views.

The EAC report does come out with specific policy recommendations in the context of its analyses of the inflation scenario expected by it at the end of the current fiscal. It recommends that the duty-free wheat imports be extended beyond the current fiscal. The continuance of duty-free imports of wheat may, however, act as a disincentive to sowing more wheat.

The crowning piece of the EAC review may lie in its cautionary observation. "The economy is growing very fast. The growth needs financing. However, it is important to manage this without slowing inflationary pressures". Curtailing money supply growth has to be an integral part of the recommended policy package. Growth requires financing, but inflation management requires containing money supply. How are we to reconcile these opposing requirements?