The Hindu Business Line : New spin on inflation spiral

The Reserve Bank of India’s Annual Report for 2007-08 does not say much that the nation did not already know from official reviews that preceded it. It records the moderation in growth in 2007-08 from the previous years and notes that the economy will still post an impressive 8 per cent growth for the current fiscal. This optimism sits well with its sunny prognosis on the various sectors and the effective conduct of its commitment to inflation control as, in its July review of the economy, the central bank states that it hopes to moderate inflation growth to 7 per cent by March. It assigns authorship of the inflationary spiral to supply constraints and global cues but its central focus continues to be demand pressures. The report stresses some key factors that contribute to such pressures, including the persisting high levels of non-food credit growth. But it breaks fresh ground by recognising two new sources of persistent demand pressures — high capital inflows and the government.

The central bank complains of greater monetary expansion because of “excess capital inflows” that reached a high point last year. The first quarter of this fiscal shows a decline largely because of net portfolio outflows, but, then, FDI has doubled, at $10 billion, from the last year’s Q1, just as funds through ADR and GDR issuances tripled to a billion dollars; NRI deposits, meanwhile, witnessed a net inflow of $360 million, in contrast to a net outflow of $446 million last April-June. Despite large capital outflows, partly on account of Indian firms shopping for acquisitions, net capital inflows increased to 9 per cent of GDP in 2007-08, from just 2 per cent in 2002. While pointing to such flows as deterrents to an effective “withdrawal of monetary accommodation” the RBI skips around the reasons for the sustained surge. High interest rates drive Indian firms abroad for cheaper capital and attract foreign capital, in turn, for the arbitrage possibilities.

The RBI, however, swings a googly when it locates another deterrent to effective inflation control — the Government. While applauding it for its fiscal prudence and a proposed decline in market borrowings in the current year, the central bank frowns at the idea of “large draw-downs of cash balances” by the Government at a time when those surging capital inflows are causing it enough headaches by adding to liquidity. Government spending, it reminds us, ought to be contra-cyclical, increasing when demand is sluggish, not when it is clipping along at fair speed. But the admonishment comes too late; also, the RBI does not tell us what the impact on government finances will be once those promises are redeemed.

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