Column : Its tough, but rates must remain low

Written by Indranil Pan | Updated: Aug 26 2009, 03:11am hrs
Rainfall deficiency extended to a cumulative of 29% till the week ending August 12th and 377 of the 533 districts of India have received deficient rainfall. Under the circumstances, agro outputmainly food-grainsis likely to be much lower than was earlier expected with the area sown under rice down by nearly 19% from last year. Now, the time for the sowing of the summer crop is gradually running out. In addition, reservoir levels are running on the lower side which limits chances for the rabi output to cover up for the loss in the kharif output.

The net effect is a race to downgrade forecasts of GDP. Government sources are strongly holding on to their estimate of a 6% headline growth for the year and I think this is achievable. First and foremost, we need to realise that the development process in India, and now the huge share of the services sector in the GDP has enabled a structural shift in the economy. What I gather is that in 1980 almost 70% of the rural income was generated out of farming and an NCAER survey showed that by 2007 this has dropped significantly. The downside implications of a poor monsoon on industrial production are thus small. Further, whoever faces loss of agriculture income now has the opportunity to replace that through earnings under the NREG programme, which has seen a large increase in its outlay for this year.

Any slack in consumption demand from the rural sector could also be made up by the urban demand. The large dose of global liquidity, positive and stronger economic fundamentals in India compared to the rest of the world have kept the asset markets in India fairly stable and this is likely to push up consumption. Further, schemes that add to the personal disposable income are in plenty, such as the awards under the 6th Pay Commission and the removal of surcharge on personal income tax recently.

Clearly therefore, the worry from weak monsoons is not because of its impact on growth. The main worry arises out of its impact on price levels. True, the foodgrain stocks as of end-July are at 57.42 million tonnes which is 16.3% higher than last year. These levels are in excess of buffer norms and can be offloaded in the open market to stop the price rise. Apart from this the strategy is to allow for larger imports to arrest the price rise. Currently, international prices of wheat are lower than last year but rice prices are sticky due to the unfavourable rain forecasts in India. However, the FAO has projected a lower output of wheat this year compared to the last, that can start to push up the international price of wheat. Further, as the international markets start to face up to the reality of rising demand from India, prices could be driven higher. Thus, the price at which India is finally able to import food-grains could actually be much higher than the current levels. The recent increase in the MSP can help buffer the downside growth implications by putting more income in the hands of the farmers who have marketable surplus. However, this is not good from the inflation perspective as a higher MSP is most likely to set a floor for price movements.

Imports or no imports, India appears to be getting caught in a high inflation zone in the year ahead. Already the prices of cereals and pulses have moved higher by 15% with cereals up by 3.5% and pulses up by 18% compared with a year ago. The surfeit of global liquidity and the hopes of a strong recovery are once more pushing up the international commodity prices, including that of crude oil. I would personally look at average WPI inflation in the next year going up to around 5.5% (higher than RBIs medium-term objective), compared to this years average of 2.5%.

And who would have forgotten the policy implications of rising price pressures of mid-2008. Supply-side and demand-side pressures on inflation are hard to distinguish in India as inflation expectations rise with wage indexation being linked to the CPI. Further, the easy fiscal policy and the large government borrowing programme would mean a continuation of the liquidity surfeit and higher M3 growth, thereby leading to fears of demand-side inflation. And experience shows that RBI could be swift in adjusting the policy rates upwards sharply once it starts tightening.

This could be disastrous. Interest rates have anyway started to firm up due to the large government borrowing programme combined with fears of additional borrowings in the wake of the drought-linked expenditures. Today, the fight is still on to ensure transmission of the earlier policy easing into the real sector. That must be allowed to happen.

The author is chief economist, Kotak Mahindra Bank. These are his personal views