Lower import tariffs to contain prices

Last fortnight, we argued that in order to ensure the domestic appropriation of the productivity gains made by our productive sector (besides making exchange rate management a little easier), stable monetary conditions need to be maintained. That is, our rate of inflation should not be much higher than that of our neighbours, which also happen to be our competitors. Over the past three years – 2004, 2005 and 2006 – China and Taiwan had average inflation of around 2%; South Korea and Malaysia were under 3% and Thailand marginally above 4%. In Eastern Europe, the Czech Republic registered 2.4% and Poland 2.2%. The OECD member economies were at 2.3%.

And the cited emerging economies have been growing quite rapidly, both in relation to their own historical experience, and relative to the rest of the world. Most of the advanced world was also doing nicely growth-wise.

The US economy has had a terrific three-year run with average growth of 3.5%, with average inflation of 3.2%; the euro-zone had a more modest three-year average growth of just below 2% and average inflation of 2.2%. All this, despite the raging prices of crude petroleum, as also of a whole slew of other primary products?from copper to timber, from meat cuts to asparagus.

The RBI has tried to put forward a target of 4% annual inflation as the first step, with a 3% rate of inflation being possibly the medium-term objective. However, as the facts testify, notwithstanding the effort of both the Indian monetary and fiscal authorities, inflation in 2006-07 has popped the unpleasant side of the surprise?with the growth and other macro-economic (investment and savings) numbers providing the pleasant part. To recollect, the fiscal year began with overall inflation of below 4% and manufactured goods inflation of under 2%. The principal risks appeared to emanate from the future course of crude petroleum price and from the increase in both domestic and world prices of wheat and other foodgrain.

The texture of the picture did not change by much during the first half of the year, although price pressure from manufactures was becoming much more manifest, albeit with a lag. Ever since the beginning of September 2006, the revised figures that follow the provisional estimates with an eight-week lag were showing an inflation increase of up to 50 basis points (bps) for manufactured goods, which is huge.

The magnitude of this spurt began to be evident in early November, by which time it was set to cross 5%. The moderation of crude petroleum prices since September 2006 provided considerable relief, though. The price pressures that have arisen in this fiscal year have many facets. On the one hand is the pressure that an economy on an unprecedented path and pace of growth is exerting on prices through the monetary transmission process. On the other hand are the two different kinds of supply constraints ?one relating to wheat, pulses and some other farm products; the other relating to manufactured goods. In the former, there was first a worldwide decline in both output and stocks over several years, and now there is across-the-board demand strength and price increases. Finally, domestic acreage and productivity appear to have peaked in India for traditional crops.

The problem is a tangled one, compounded by the complicated skein of input and output subsidies that we have wrapped our farm sector in. In the case of manufactured goods, the issue is more near-term. With operations in a host of industries running close to capacity, pricing power has reappeared.

Domestic competition, more than import competition, had in the past made producers assign the highest priority to market share. Today, with little excess capacity, and by implication market shares frozen, pricing power has come to the forefront. Which is not entirely a bad thing, for fat profits motivate new investments. For policymakers, however, the only means of injecting competitive pressure is to make imports cheaper, by cutting duties.

Several import duties were reduced recently, but there is scope for cutting many more. In the forthcoming Union Budget, the peak customs duty could be reduced from the present level of 12.5% to 10.0%. While some may want a deeper cut, it is more important to restrict the application of the peak duty to only finished consumer goods. Much of what we import is raw materials, intermediates, semi-manufactured goods and machinery.

While there are a number of items attracting 2% today (ores, for example) and 5% (metals), many more products could be brought into the band of 5% and below. We should not be excessively concerned with the apparent virtue of having only a few rates in the name of ?simplicity?. If a multiplicity of new rates helps in lowering overall import protection, so be it. The lowering of import duty protection will not only assist in injecting greater competition in manufactures and assist in stabilising prices, it has the potential of enlarging the merchandise trade deficit and hence the current account deficit to a level which is more in consonance with the flow of capital into the country.

Indian industry will also be working with a level of protection at which its ability to innovate and pare costs will be in greater evidence. Finally, lower import duties will make the task of operationalising the several Free Trade Agreements (FTAs) that India has signed, or are in the process of negotiation, that much easier.

?The writer is economic advisor, Icra