There is always a trade-off between price stabilisation and growth, says Ms Sonal Varma, India Economist, Nomura Financial Advisory and Securities (India), in an interview to Business Line. Excerpts:

Would price stability, while maintaining growth, become increasingly difficult?

The trade-off is always there, but it depends on the level of inflation. Now, 8.5 per cent is clearly too high for comfort. In the long run, you cannot also sustain growth if inflation continues to be so high.

So you believe that measures to curtail inflation could end up affecting growth?

I would like to mention here that it is also partly the objective — tightening policy to bring growth to more sustainable levels.

If you look at the last two-three quarters, we have been growing at close to nine per cent, whereas our view is that not enough has been done in terms of investment to raise agricultural productivity or improve infrastructure so that it leads to better efficiency.

So, every time the economy grows too fast, it leads to inflationary pressures. One of the objectives through policy tightening is to normalise growth to more sustainable levels, where inflation can also be controlled.

How much of the inflation is demand-driven vis-à-vis supply-side constraints?

I think it is a mix of both because at the end of the day, clearly, on the food side, a significant portion is driven by supply-side constraints. But there is a segment of food that is seeing sustained increase in demand. If you see the kind of income growth in rural areas (of course, it is going to lead to a greater intake of protein, which is what the Reserve Bank of India has been highlighting), it is evident disposable income is going up.

How representative is WPI as a headline inflation number? How does it compare with developed nations' indices?

In case of developed nations, since their per-capita income is so high, typically, weightage of food in their consumption basket is very low. For instance, while CPI has a weight of 46 per cent (food) in India, most developed economies will have a 15 per cent weight for food.

The second difference is the kind of products. In developed nations, processed items have more weightage as against higher weight for raw materials in developing nations such as India.

Therefore, if there is some price shock, it affects developing nations more. Typically if you have a greater share of processed food, you have some capacity to absorb costs in the supply chain which doesn't exist for developing countries .

The NREGA wage hikes once again promise to support consumer sectors. What kind of scenario could pan out for the consumer-driven sectors?

Rural demand, as you said, is more a structural story and the wage hikes are only going to reinforce that. In 2010, there was to some extent demand, which came from postponement of consumption decisions during financial crisis. Then with improvement in income, job prospects looking better and asset prices doing well – there is some wealth effect also.

Not only has demand gone up, but also the entire demand that was postponed has seen a big pick-up in 2010. A repeat of this as far as the consumption side is concerned will be very difficult, mainly because there was an element of pent-up demand that boosted consumption this year.

IIP consumer goods numbers have been particularly surprising; the non-durable segment, in particular, has been weak for quite some time. But that does not seem to tie up with the private final consumption expenditure numbers on GDP which actually shows a fairly good rebound on the consumption side. And even anecdotally, the feedback we have been getting is that the consumption side is fairly strong.

So, overall, I believe that the rural demand side is strong, but there will be some moderation on the consumption side as some of the one-off factors won't be there. But the underlying drivers of consumption demand are income security and income prospects and these look fine.

Exports as well as consumer-driven manufacturing have been doing well. Still, we have not seen any evidence of strong revival in capex.

I think that has more to do with business confidence. This is ultimately what drives investment. It is about whether you think there is demand or not, then there is cost of financing and the policy environment. Cost of financing has been going up, but I don't think it has gone up to a level where it severely hampers growth.

Domestic demand is looking good, consumption is doing well and if exports continue to do well, then capacity utilisation rates should be picking up.

So that leaves business confidence as one reason for some push-back on the capex side. The bigger issues such as policy environment in terms of land acquisition, labour shortages etc do dent confidence.

But having said this, the first six months of this fiscal had seen gross fixed capital formation grow by 15 per cent (real increase).

You said cost of financing is not much of a threat now. But given the tightening expected over the next year, won't interest cost be a risk in FY-12?

Definitely, the delta increase in cost is going to be much more in the next financial year. From the investment side, historically, few would have seen interest rate as a driver of investment, in which case you would have never expected the investment cycle to pick up between 2005 and 2008.

What also matters is the access that industries have to other sources of financing in terms of external financing and equity financing; not just debt financing where of course costs have gone up.

So the overall context of cost of financing has to be seen, other than the RBI hiking rates.

The RBI has increased repo rates by 175 basis points and money market rates have gone up 300 basis points.

But if you actually look at how much bank lending rates have gone up, I don't think it is more than 100 basis points.

Corporates have also been pressured by commodity price hikes and some of them have already been passing it on. Would this stoke inflation further?

Yes, that's one of the reasons why we do think inflation is going to stay stubbornly high. We expectan average WPI of 7.5 per cent for the next financial year. Food inflation is one of the reasons.

Secondly, as you mentioned, margin pressure would lead to some pass-through to consumers. Wage inflation is also a concern. So, inflation may continue to remain the main challenge next year also.

With rising food subsidy and fuel bills, lower income from disinvestment and little prospects of revenue on the lines of spectrum fees, what would be the impact on fiscal deficit in next financial year?

We do see slippage next year, due to elevated expenditures and limited scope of revenue next year.

In that scenario, we expecta 5.2 per cent deficit next year where as FRBM requires the fiscal deficit to be brought down to 4.8 per cent of the GDP. This year has been easy with one-off bonanza from 3G.

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