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India: inducing a slowdown through restrictive policy January 15, 2010

Posted by southasiamasala in : India, Jha, Raghbendra , trackback

Raghbendra Jha

Indian policymakers pride themselves on the fact that the Indian economy was able to pull out of the Global Financial Crisis (GFC) relatively unscathed with real GDP growth rate falling to 6.7% in 2008-09 as compared to the 9 per cent in 2007-08 and expected to rise above 7 per cent in 2009-10.   At the onset of the GFC many commentators had expected a collapse of growth with some even predicting a return to the sluggish growth of the mid to late 1990s.

Thankfully, the Indian economy proved the predictors of doom wrong.   A number of factors have been ascribed to explain this performance: high consumption in India, as compared to China, and lower exposure to the global economy, again as compared to China.   High home consumption is desirable as it gives support to the domestic economy in the face of a collapse of international trade, as happened during the GFC.  Additionally, lower exposure to international trade reduces the impact of external shocks.  The existence of substantial controls on the banking sector is said to explain the fact that no Indian bank had to be ‘rescued’.  In addition, however, credit is sometimes also given to ‘good policy design’ by the government. 

The first two factors are certainly true.  Indians save just over a third of their income and invest a bit more whereas the Chinese save and invest well over half of their GDP.   India’s trade exposure as measured by the percentage of exports plus imports to GDP is a fraction of China’s as is India’s exposure to global financial flows.  However, as the Reserve Bank of India (RBI) has reminded us, India’s exposure to global financial flows is growing very rapidly at the margin, particularly as a consequence of significant liberalization of the capital account as it applies to corporates. 

For both these reasons, then, Indian growth rates should have been higher than China’s!  Why then is China’s growth rate substantially higher than India’s and why is the gap only expected to rise in 2010?  In particular, should the difference be ascribed to differences in policy in the two countries?  In particular, attention has focussed on the much larger stimulus package in China than in India – something that was possible for China because India has a much larger fiscal deficit and much smaller fiscal room to manoeuvre.  However, we could accept this argument only if we control for the much larger shock that the Chinese economy with its lower consumption rate and higher exposure to external shocks was subject to as compared to the Indian economy.  This has not been demonstrated so no claim of this sort can be made. 

What can be commented on is the course of Indian economic policy during and after the GFC (assuming we are out of it).   Even before growth rates had picked up sufficiently and when there remain question marks on the pace and extent of global recovery, monetary policy has tightened.  A crescendo of voices raises hackneyed arguments about the need to control the fiscal deficit even though the greatest debtor of all (the US) is approaching this issue with greater equanimity and may yet use deficit reduction strategically. 

Some have argued that high inflation in India necessitates the tightening of monetary policy.  But, inflation in India is not a homogeneous entity.  Even at the height of the GFC with wholesale price index (WPI) inflation reaching alarmingly low levels, cost price index (CPI) inflation was high in India.  As of November 2009, the latest period for which the Ministry of Finance has made data available, year-on-year inflation in terms of WPI was 4.78 per cent for as compared to 8.48 per cent in November 2008 whereas CPI inflation was in the double digits.

This, however, is not an argument for monetary tightening.  A key contributor to the recent dynamics of CPI inflation has been the rise in procurement prices of foodgrains just before the Lok Sabha elections of 2009.  Prior to that, food prices had been rising and under pressure the government imported foodgrains (at substantially higher prices than was being paid to Indian farmers). The rise in procurement prices was inevitable, particularly given that 2009 was an election year.  That rise in procurement prices is now filtering to higher wholesale and retail prices, leading to further imports.  These imports would again be higher than the prices being paid to Indian farmers whence there will be pressures for the procurement prices to be raised.

In this context restrictive monetary and fiscal policy will certainly lower growth and, perhaps, WPI inflation and hit the balance of trade. CPI inflation has a dynamic all its own.


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