MAVERICK VIEW. No easy path to higher growth

It is important that government, policymakers, opinion-makers, industry and other stakeholders give serious attention to the Reserve Bank of India’s Annual Report 2013-14, especially as it provides a goldmine of ideas for improved overall macroeconomic policy.

With greater political stability, the move towards fiscal consolidation and strengthening of the monetary policy framework, GDP growth in 2014-15 would be around 5.5 per cent.

Risks to growth as also upside risks to inflation arise from the sub-optimal monsoon and the geopolitical situation in West Asia.

There are always aspirations for a quick return to the halcyon days of 9 per cent growth. But the RBI does well to caution that for a medium-term growth of even 7 per cent per annum, it is imperative to have better microeconomic policies to improve activity and productivity; this should go along with a conducive macroeconomic environment with reasonable, positive rates of interest, low inflation, moderate balance of payments and current account deficit, (CAD) and a low fiscal deficit.

Higher growth does not come easy. The Government has been responsible in not generating expectations of an early acceleration of growth.

Even to have a sustained growth of 7 per cent per annum in the medium term will require considerable effort in terms of a better macroeconomic balance.

A major prerequisite is lower inflation. It is for this reason the RBI stresses the need to contain inflation to 8 per cent by January 2015 and 6 per cent by January 2016.

At the present time, 8 per cent inflation for January 2015 appears reasonably secure, but a lot more needs to be done to contain inflation to 6 per cent by January 2016.

There is an asymmetry in that when inflation falls there are pressures to reduce policy interest rates, but there is no support for higher policy rates when inflation rises.

Hence, it is best to leave the RBI to take a considered call on when it is appropriate to reduce interest rates. It is gratifying that the new government has reduced the sabre-rattling, urging lowering of interest rates. It would strengthen macroeconomic policy if the Government were to refrain from expressing a hope for lower policy rates.

It is often not appreciated that a small reduction in interest rates has very little impact on reducing the cost of production.

On the contrary, excessively low real rates of interest can easily generate a resurgence of inflation.

According to the RBI, gross domestic savings have declined from an average of 35 per cent of GDP from 2005-06 to 2007-08 to a nine-year low of 30.1 per cent in 2012-13. Household sector savings have fallen from 25.2 per cent of GDP in 2009-10 to 21.9 per cent of GDP in 2012-13.

What is alarming is that household sector net financial savings have fallen from 12 per cent of GDP in 2009-10 to 7.1 per cent in 2012-13. In contract, gross savings in physical assets rose from 13.2 per cent of GDP in 2009-10 to 14.8 per cent in 2012-13.

These numbers provide a telling message that financial savings are not attractive and savers prefer physical assets. This is not surprising as inflation has eaten into real financial savings and nominal interest rates are low given current inflation levels.

As such, much of the clamour for lower interest rates is misplaced. Bringing down inflation should be the topmost policy priority.

The RBI is optimistic that the gross fiscal deficit (GFD) and the CAD in 2014-15 would moderate. According to the RBI, the reduction in the GFD to 3.6 per cent in 2015-16 and further to 3.0 in 2016-17 is feasible, but requires further expenditure reduction and better targeting of subsidies.

The RBI advocates a quick pass-through of global crude oil prices and also early measures for more flexible diesel, LPG and fertiliser prices.

There is a need for better appreciation of the impact of increased administered prices. Illustratively, in the case of imported crude petroleum, India would have already paid the international price. By holding down administered prices, sectoral prices are kept down, but such measures cannot keep down overall inflation.

On the external front, in 2014-15, there are upside risks to oil prices due to geopolitical developments as improved domestic demand could increase imports.

Again, a faster monetary policy tightening by the industrial countries could put pressure on India’s CAD.

While higher exports are important, it is essential that the exchange rate be competitive. In particular, the macho spirits pushing for an appreciation of the rupee exchange rate should be resisted. An appreciation of the rupee vis-à-vis the major currencies is totally unwarranted as India’s inflation rate has been persistently way above inflation in major industrial countries.

The RBI has aptly set out the key challenges for the ensuing period. First is the need for lowering food inflation through supply side measures. Second, strengthening the monetary policy framework and improving the transmission process. Third, fiscal consolidation through better targeting of subsidies and revenue augmentation. The revenue to GDP ratio in India is significantly lower than in industrial countries.

There is a need for direct tax reforms taking into account the principles of efficiency, equity and effectiveness. The direct tax structure reflects gross inequity, in that some individuals with very large incomes and assets are free from direct taxes while some with moderate incomes are subject to relatively high direct taxes. (to be continued)

The writer is a Mumbai-based economist

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