The practice of borrowing short-term money to finance the current account deficit cannot be sustained for too long, warns Kaushik Basu, chief economic advisor in the finance ministry. In an interview with KG Narendranath and Subhash Narayan, Basu calls for ?putting our minds together? as to how to deal with the rising deficit. He says there has to be a policy for shifting some of our vast rural land for industrial development and manufacturing. He also discusses a host of other questions ? the spurt in global commodity prices, the slowing down of FDI inflows, the ?dilution? of key tax reforms like DTC and GST and the need for completing fuel price decontrol, besides sharing his views on the lingering uncertainty about the recovery of global economy.
In the last two-three weeks, there has been a spurt in food inflation, even as the overall inflation rate seems to moderate rather slowly.
One reason why the situation looks worse now than what we had anticipated earlier is the spike in the prices of food items?fruits, vegetables, milk ?due to small disruptions in supplies and speculative build up around those incidents. This happened over the last two or three weeks. However, I feel that, in itself, the current spike in certain food prices is not a cause for long-run concern as it is caused by small disruptions in supplies of individual commodities?an episodic factor one should not read too much into.
The real reason why the current inflation scenario is looking somewhat worse than earlier is more to do with things that are more permanent in nature ? for instance, the fact that the overall commodity price scenario globally has deteriorated.
We (the finance ministry) had a few weeks ago revised our inflation forecast. The earlier forecast of headline inflation moderating to less than 6% by March-end no longer looks realistic. We now expect the fiscal year to close with an inflation of around 6.5%. Inflation at 6.5% is not as bad as where it was a year ago, even though our aim is to bring it down even further.
The fear is that inflationary expectations could feed on themselves and result in an asset price bubble.
With the increasing currency competition between the industrialised countries and China, many central banks are releasing more money into their own economies and this does create some risk of asset bubbles. When the world was not as globalised as it is today, the effects of an increase in money supply by a central bank used to be felt only within the geographical confines of the economy concerned. No longer so. In today?s globalised world, barriers (between economies) have diminished and money released in an economy, especially if it has a globally convertible currency, often flows out into other economies. What is making India more vulnerable in this context is that while some countries are going in for easy money policy, some others like South Korea, Taiwan and Switzerland are putting up some kinds of walls against these money flows. It is this international scenario that causes the long-term prospect on Indian inflation look a little worse now.
Of course, rising food prices are distressful to consumers, even if these are episodic phenomena. There is justification for government intervention when there is a spike in overall inflation. However, when there is a relative price change in certain commodities due to factors specific to their supply and demand, it is not always desirable for government to step in. Relative price changes are signals given by the market, and it is harmful to switch them off altogether.
What is true is that we have not covered ourselves in glory in managing agricultural production and distribution. Quite apart from the problem of inflation we in government need to work on this actively and, more importantly, imaginatively.
The question about how effective is the monetary policy to impact inflation is turning more relevant.
In today?s globalised world, the efficacy of monetary policy is by definition less. When you release money into your economy, part of this flows out in today?s world; and when you tighten money, a part of this tightening is undone by outside money coming in. Also, in today?s world, liquidity is not created only by government and its central bank but the actions of hundreds of individual banks and financial entities. Economists call the latter ?inside money.? Much of this lies beyond the direct purview of government. For these reasons, each individual central bank’s policy is no longer as effective within the country as it once used to be.
It is being pointed out that the base effects that impact inflation rate would wear off by February and that the build-up of inflation is already not there.
The base effect is already all but gone. There are only two, relatively small base effects still to come. One is for food articles in early January and the other is for WPI inflation for the full month of January. The former should cause the weekly food inflation figure that we will get on January 13 to be lower ; and the latter implies that the monthly WPI inflation data that will be released in mid-February should show a drop in inflation. Apart from these two base effects, we are now pretty much on our own.
Is it that we are resigned to the fact that for a long-term, inflation would remain elevated?
We will probably have to live with a little higher inflation than we have done in the past. When a country grows very rapidly, there is inevitably a tendency for domestic prices to catch up with international prices. The example of South Korea is before us. We know from purchasing power parity calculations that Indian prices are about a third to a fourth of the prices in industrialised nations. If, over the next 30 years, we are going to break into the bottom ranks of industrialised nations, there will inevitably be a bit of catch-up on prices. This could mean an additional 1.5 to 2% inflation per annum, which we will have to get used to as a concomitant of rapid growth.
The lingering uncertainty about the global economy is a cause for concern for India too. Estimates say that the Euro zone economy could slow to more sluggish 1.5% next year from 1.7% in 2010. Although the forecasts of the US economy is slightly better, the unemployment rate in the world’s largest economy is a worrisome and persistent 9.8%. On the one hand, we have large economies resorting to austerity steps and, on the other, the threat of overheating in emerging economies.
The global scenario is more worrying than it appears at first sight. As for the US economy, some indicators do show an improvement but unemployment, at just below 10%, is holding steady or even rising. Worse, a breakup of this employment figure shows that around 40% of this is long-term unemployment. These are people who are not only unemployed but have remained so for more than six months. There are studies to show that people who remain unemployed for long begin to lose their work skills. This can have long-term adverse structural effects on the economy. Even in some parts of Europe, for instance, Spain, the unemployment problem is very large. On top of that Europe has its sovereign debt problem.
The world trade is impacted by the global economic situation and that is bad news for our exports.
India’s exporters will have to face some hardships as a lot of our exports, especially those of services, are oriented towards industrialised nations. However, China has become among the two most important trading partners for India in the last few years. We should look at expanding trade to other emerging economies in Asia, Africa and Latin America and also begin to promote rupee denominated trade. If the economic slowdown in the US and Europe persist, that way, our risks will be hedged. Of course, this (trade shift) cannot happen overnight. So, a slowdown in global trade growth will hit us. In fact, it is already affecting us, as is seen from our high current account deficit. Our exports are trailing way behind our imports.
India’s current account deficit in July-September quarter widened to a record high of $15.8 billion. This has added to the credibility of worrisome estimates (3.5-4% of GDP) of the deficit in the current fiscal. Goldman Sachs has predicted an even higher deficit of 4.3% in the next fiscal and reckons this is a risk for the Indian economy.
I’m concerned about the current account deficit ? not the size per se but the fact that a large part of this deficit is financed through short-term capital flows. This practice of borrowing short-term money to finance the gap cannot be sustained for too long. So, this is something that needs to be watched carefully. We need to put our minds together as to how to deal with the rising current account deficit. If the deficit is financed through stable money flows, then it is fine. But that doesn’t seem to be the case right now and the policymakers will have to pay attention to turning this gap around.
Isn?t the slowing down of FDI inflows a cause for concern? The hassles being faced by some of the large FDI investors like Posco seem to have impacted the outlook of other potential investors for India.
I?m in favour of easing FDI flows. There are two ways to correct the slowdown in FDI into India. One is to improve the business environment in the country, that is, to have a more efficient business bureaucracy; and the second is to open up newer avenues for FDI flows. I personally feel that FDI in multi-product retail is important. There is no consensus in India on this issue. I believe FDI in retail will ensure better price for farmers and lower price for consumers. Modern supply chain management can help squeeze out the excessive margins between farm gate price and consumer price.
The question of environment versus development is in focus with no clear and comprehensive policy formulation in sight to resolve it. For the industry, getting land for projects in time continues to be rather difficult. What are your views in this regard?
You cannot allow industry to ravage our environmental resources. On the other hand, it has to be borne in mind that India has a very large number of poor people and industrialisation and economic growth are integral to improving their lot. You cannot hold back the economy endlessly when the suffering goes disproportionately to the poorest segments of the population. What’s required is to strike a balance between the need for the economy to grow and have this filter down to the masses and the need to protect the environment for future generations.
The main risk comes from being single-minded.
On making land available for industrial projects, I believe there has to be a policy for shifting some of our vast rural land for industrial development and manufacturing. This policy has to be implemented mostly in remote areas so as to benefit the large number of Indians who live in poor regions and rely solely on agriculture for a living. India’s agricultural production is 14.6% of GDP even as 58% of people live on agriculture. You need to draw some of these people into industry if you want them to have a higher standard of living. But you don’t need to bring them all to cities and cause further overcrowding. So, the development of small industries and service activities, scattered all over the country in small towns and semi-rural areas, is the critical need for India. For this there has to be a rational policy for transferring some land from agriculture to industry. If a few essential prerequisites like power, water and law & order are ensured, small industries would spring up on their own all over the country, conferring great benefit to our current farm labourers.
We do have enough land for agriculture that some of this land can be shifted to industry. At the same time, we have to work to raise agricultural productivity through better irrigation, regular power supply, and more widespread procurement windows across the length and breadth of India. In many parts of India, the MSP (minimum support price) is a purely notional price because there is no window where you can sell your produce.
Many of the reform measures like GST, DTC appear to get diluted in the course of their conception and designing. What are other reform measures that should be high on the policymakers’ agenda?
As regards DTC, some watering down is understandable because it is being done to avoid problems for those who have already invested relying on the promise of the certain tax benefits. It is unreasonable to take away the benefits midway when the investments were made because of these incentives. The right way to handle these is to have sunset clauses. To start with, some exemptions may have to remain. But over a short time horizon, a few years, these remaining exemptions should go, and the investors must be given notice as to when and how this will happen. The goal is to ultimately move to a regime where tax rates are flat, sans exemption. The Goods and Services Tax is a very important tax reform and we need to make it as comprehensive as possible. We are a little behind schedule compared to what we had expected early in 2010, but we will get there.
On reforms in general, my view is that we should look at completing the decontrol of petroleum and diesel prices, which began with the partial decontrol of petrol prices in June. What we need is to have a rule-based system, where the domestic prices would automatically reflect the global crude market and the exchange rate. Government can set this rule but should not be involved in day-to-day price fixing. The latter invariably leads to cronyism. What is needed is a clear-cut formula that is transparent and allows private firms to make future plans, without having to live with policy uncertainty. This will enable private players to enter the market and compete; and it will vastly reduce the scope for political lobbying.