They say lightening never strikes twice. Well, it did in India. And that too in the same week. A few weeks ago, the government was embroiled in another controversy around resource allocation, Parliament was again in lock-down, and the odds that any bold decisions would be taken appeared as remote as a lightening strike.
But not for nothing do they say it?s darkest before dawn. With growth continuing to weaken, inflation refusing to abate, industry stagnant, consumption moderating, and the sword of a downgrade dangling around the economy, the government perhaps felt that there was nothing more to lose. And came out swinging.
First came the fuel price hike. Increasing diesel prices by R5 may seem inadequate given the under-recovery was approaching R20 a litre, and is likely to rise as commodities rally further in response to more monetary expansion in developed markets. But given the political constraints at play, the fact that a R5 hike was unprecedented, and would eventually impact inflation by 80-90 bps itself, it was a bold move.
Some will argue it does nothing to dent the fisc. They are right. Fiscal savings are only 0.1% of GDP. More will have to be done to ensure that the fiscal deficit doesn?t print close to 6% of GDP. And, hopefully, at some point in the future, the government will take oil subsidies to their logical conclusion by fixing the subsidy per litre/cylinder so that Budget allocations are fixed and, more importantly, households experience price fluctuations and adjust their consumption accordingly.
But what was important here was a demonstration of intent. That the government is finally prepared to take hard-nosed decisions. And that show of fiscal intent will go a long way in postponing?and potentially even warding off?a ratings downgrade that could have a catastrophic impact on corporate India.
The same intent was at play 24 hours later when the government approved a slew of long-standing FDI proposals?from the controversial multi-brand retail sector, to aviation, broadcasting and power. The message was clear?the country is open for business again; FDI is actively welcomed, and jump-starting investment?both foreign and domestic?is a key priority.
Some will have doubts on whether things will really change on the ground. Won?t politics prevent a majority of states from signing up for multi-brand FDI? And, if so, how much of a game-changer will this really be? Will India?s troubled aviation sector evoke any foreign interest at all?
These are legitimate question for the near term. But they miss the larger point. Undoubtedly, some of the investment slowdown is on account of implementation bottlenecks but a lot of it is because investor sentiment and psychology are at all-time lows. An air of resignation had crept into the corporate sector that the government does not care about improving the investment climate, and corporates should increasingly look outwards. Hopefully that notion will have begun to get dispelled now. To the extent that the collective impact of these moves signals a new regime is in place and a corner has been turned, the psychological impact of boosting sentiment and reviving animal spirits cannot be under-estimated. But now the government needs to quickly move on resolving?as best it can?implementation bottlenecks on the ground: fast-tracking environmental and other clearances, coming up with a coherent strategy on coal linkages, diluting the retrospective tax provisions, and pushing ahead with infrastructure investments. Only these measures will ensure that the positive sentiment translates into activity on the ground.
In the medium term, however, attracting more FDI has the potential of being transformative for many sectors. But, beyond technology transfers and productivity gains, there?s another value to FDI that is often missed. There was a time when it used to finance half our current account deficit (CAD), and make the economy far less susceptible to ?risk-on, risk-off? flows such as trade credits and portfolio investment. But over the last two years, it has financed only a quarter of the CAD?leaving us more exposed to volatile capital flows and sharp gyrations in the exchange rate. So the more FDI, the better.
So what does all this mean for today?s RBI meeting? With the government having moved, it is tempting to believe RBI will return the favour through a rate cut on Monday, as part of a coordinated package to boost sentiment.
But I believe this would be a dangerous course of action. Retail inflation is still in double digits, the momentum of core wholesale inflation has risen from 2% to 6% in just the last three months, the cascading impact of the diesel price hike is bound to stoke more inflationary expectations, and global commodities and crude are headed up?not down. In this environment, RBI should not be in the business of boosting sentiment, but instead trying to control deeply entrenched inflationary expectations and maintaining a semblance of macroeconomic stability.
The government?s moves are clearly very positive, But they will take time to jump-start investment and create much-needed capacities. Till that happens, inflation is likely to remain elevated. And stubbornly high inflation?by squeezing purchasing power, especially of the poor?has been a key culprit in depressing consumption (see chart). So RBI cannot afford to lose its nerve now. Paul Volcker took years to tame inflationary expectations and rid the US of its stagflation. But in the end, he was very successful.
India needs both high investment and low inflation. The former will eventually result in the latter. But till that happens, high inflation?by keeping input costs high and depressing consumption?can choke off investment. So the division of labour should be clear. Let the government focus on boosting sentiment and reducing supply constraints to crowd in investment. And let RBI focus on containing inflation and inflationary expectations, which will boost consumption. Mixing these objectives could undo the hard-earned gains from the last week.
The author is India economist, JP Morgan