GROWTH PATH TAKES A U SHAPE

GROWTH PATH TAKES A U SHAPE

Increased globalisation, however, makes high growth challenges more complex


During the last two years, the Indian economy has been buffeted by three major challenges originating in its external sector. First, a surge in capital inflows, which reached a crescendo in the last quarter of 2007-08 . Second, an inflationary explosion in global commodity prices, which began even before the first challenge had ebbed, that hit us with great force in the middle of 2008. There was barely any time to deal with this problem before the third challenge, the global financial meltdown and collapse of international trade, hit the world with severity. Despite some difficult choices and ambiguities , arising from the rapid changes in the global situation, the short-term challenges arising from these global shocks have been met. Each of these, however, has implications for the medium term, that requires a considered and integrated response if our objective of sustained high growth is to be realized. An analysis of the impact of these shocks brings to the fore the importance of pursuing reforms, including in the financial sector, to make the economy more competitive and the economic regulatory and oversight system more efficient and sensitive to new developments.


The Economic Survey of 2007-08 (February 2008) had pointed out that There is now no doubt that the economy has moved to a higher growth plane, with growth in GDP at market prices exceeding 8 per cent in every year since 2003-04 . It had however warned that The new challenge is to maintain growth at these levels, not to speak of raising it further to double digit levels. Further, The challenges of high growth have become more complex because of increased globalization of the world economy and the growing influence of global developments, economic as well as non-economic . Ten months later, the Mid-Year Review (December 2008), noted that We should be prepared for growth in 2008-09 as a whole to be around 7 per cent. The experience of economic growth in a wide range of countries across the world and over different periods of history bears testimony to the fact that such setbacks are common . The experience of high growth economies (HGEs) suggests that these can be overcome by appropriate, pragmatic (nonideological) and expeditious action to address the problems that the shocks expose and by seizing the opportunities that they open up. This is what distinguishes the few economies that sustain growth over decades (by returning to high growth after a temporary setback) from the many that fall by the wayside (returning to slower growth after a temporary spurt of high growth).
The challenges that confronted the Indian economy in 2008-09 and continue to do so in 2009-10 fall into two parts. The short-term macroeconomic challenges of monetary and fiscal policy and the medium-term challenge of returning to the high growth path. The former covers issues such as the trade-off between inflation and growth, the use of monetary policy versus use of fiscal policy, their relative effectiveness and coordination between the two. The latter includes the tension between short- and long-term fiscal policy, the immediate longer term imperatives of monetary policy and the policy and institutional reforms necessary for restoring high growth. This chapter reflects on some aspects of these issues.

GLOBAL DEVELOPMENTS AND THE INDIAN
ECONOMY,2008-09



COMMODITY PRICES AND INFLATION


During the five-year period of high growth from 2003-04 to 2007-08 , WPI inflation has gone through two cycles. The first peak in August 2004 was followed by a trough in August 2005 and the second peak in March 2007 followed by a trough in October 2007. The subsequent upturn in prices therefore followed the upturn in total capital inflows during 2007, which peaked at nearly 13 per cent in the July- September quarter of 2007-08 . The focus of macro management in general, and monetary management in particular, has been on the implication of capital inflows on foreign exchange reserve accumulation, sterilization and the exchange rate. As capital inflows were far in excess of the current account financing requirements, and given the history of capital flow volatility into emerging markets, prudence required that a part of these excess inflows be accumulated as reserves. This also has the effect of moderating any potential volatility in exchange rates arising from capital flow reversals . However, the accumulation of foreign exchange reserves by increasing the monetary base also raised the issue of the degree to which the accumulation should be sterilized. The authority given to RBI to issue Market Stabilization Scheme (MSS) bonds backed by the Government of India was adjusted (in April and August 2007) to provide the required flexibility to RBI. The attempt to manage the build-up of liquidity over this period by running a cautious monetary policy, while balancing the liquidity requirements of a fast growing economy, bore fruit for most part of fiscal 2007-08 as the 52-week average WPI inflation remained at about 4.7 per cent and the GDP growth rate for the economy was 9 per cent. However, a sudden spurt in international commodity prices in the last quarter of calendar year 2007 started creating pressures on domestic prices of tradable goods, though an appreciation of the rupee during the last quarter of 2007-08 , partly dampened the pass through of global commodity price increases.
Crude oil prices rose from an average of 90.7 US$/bbl in January 2008 to a monthly average peak of 132.8 US$/bbl in July 2008, touching a high of 147 US$/bbl in this period. Similarly, among the imported edible oils, namely, palm and soyabean the prices rose from 1,059 US$/MT and 1,276 US$/ MT in January 2008 to a monthly average high of 1,213 US$/MT and 1,537 US$/MT in June 2008, respectively. Inflation, which had declined to less than 4 per cent in the middle of August 2007 and had remained so for 20 consecutive weeks thereafter, started firming up from December 2007. During December-March 2007-08 , there was an increase in the prices of coal, iron ore, iron and steel products and prices of petroleum products not covered under the administered price mechanism. The rising oil prices necessitated an upward revision in the administered prices of petrol, high-speed diesel and LPG in first week of June 2008. Together with a continued hardening of global commodity prices these developments led to a sharp increase in the headline WPI inflation rate, touching double digit level by the middle of June 2008. It persisted at that level for the next 21 weeks with a high of 12.9 per cent in early August 2008. Nearly two-thirds of this rise in inflation was due to three sets of commodities namely, edible oils (including oilseeds and oilcakes), iron and steel (including iron ore) and mineral oils and refinery products.
Given the global origins of this inflationary episode, a judgement had to be made about the relatively temporary versus the relatively permanent elements. Appropriate fiscal and monetary measures had to be introduced to meet these elements . Given the degree of uncertainty about the exact proportion of temporary and permanent elements, a perfect response would have been unrealistic. On the monetary side, given the lags in monetary policy , the primary objective had to be the moderation in inflationary expectations and to ensure that money supply did not accommodate the permanent elements of the global cost push.
On the fiscal side, the temporary elements had to be met by making temporary reductions in the import duties on tradable goods whose prices showed unprecedented increases. Import duties were consequently reduced on the three sets of commodities mentioned earlier. The fiscal management of agricultural commodities subject to higher duties and some elements of quantitative intervention in the domestic or international sphere was more complicated. This is particularly true of basic agricultural consumer goods like cereals and pulses that affect millions of poor consumers and small farmers (producers). A combination of import tariff reductions, export duties and changes in quantitative measures for import and/or export had to be used to manage the trade-off between poor consumers and the livelihood concerns of poor producers. Though the management proved largely successful, a rational long-term framework needs to be developed, which balances the concerns of poor consumers and producers to promote efficient growth and livelihood security . One possible approach is to have an announced price band for domestic prices (which could itself evolve gradually over time) within which imports and exports are freely allowed without any duties and controls. If international prices change beyond this band, domestic prices would be systemically dampened through imposition of variable import and export duties, depending on whether international prices fell below the lower band or rise above the upper band respectively. This along with targeted subsidies, such as the PDS, would help balance the interests of farmers who need a predictable price regime to plan their cropping patterns and those of low income households.
The rise in global oil price, along with the rise in prices of other imported commodities, had a strong adverse impact on the balance of trade. Oil imports are the predominant driver of total imports. Given the administered price mechanism for petrol and diesel, the sharp rise in oil, petrol and diesel prices required a decision on how much of this price could be passed through to users/consumers. Conceptually this too requires a judgement on how much of the rise is permanent. Ideally, the entire permanent element of the price rise should be passed through along with part of the temporary increase. With oil prices overshooting to double the long-term supply price of oil, the question of (directly or indirectly), temporarily taxing resource rents is also relevant. In practice, these issues were addressed somewhat imperfectly through a sharing formula that represented a mix of government subsidy, taxation of rents and some pass through. Consequently, the fiscal deficit, adjusted for below the line items, was negatively impacted by the global price developments. This also gave rise to a dilemma between two aspects of fiscal policy. From a macro perspective, the external shock could have been addressed by accommodating the short-term shock and tightening the fiscal policy to give a long-term signal that the one time (temporary) price increase would not be allowed to translate into inflation (a continuing rise in prices). However, the political constraints and social arguments for dampening price pass through necessitated an increase in the fiscal gap. This in turn put greater pressure on monetary and other policies to moderate inflation (e.g. temporary controls under the Essential Commodities Act) that had little to do with domestic factors. Monetary management was also complicated by the fact that capital flows changed course in the first quarter of 2008-09 and trended down throughout the year. This affected foreign exchange reserves, exchange rate expectations and reserve money accumulation.
GDP growth was also affected by these developments as the worsening of terms of trade arising primarily from the rise in oil prices acts as an implicit tax on the citizens of the country, thereby reducing private consumption demand in the first half of 2008-09 . Moreover, efforts to curb inflationary expectations necessitated a rise in interest rates and mopping up of liquidity in the economy, which influenced the growth rate, both from the demand side, as well as from the supply side.
The global financial meltdown resulted in a bursting of the commodity bubble, leading to a dramatic drop in most commodity prices. Crude prices dropped to around 40 US$/bbl by December 2008. Thus, the global cost push that was primarily responsible for raising WPI inflation to double digit levels during 2008-09 , went into reverse gear after July 2008. Consequently, by end-March 2009, the WPI Index was virtually back to the level that prevailed a year before.

FINANCIAL CRISIS AND THE GLOBAL SLOWDOWN

The global financial crisis surfaced around August 2007. Its origin lay in structured investment instruments (Collateralized Debt Obligations, synthetic CDOs) created out of subprime mortgage lending in the United States. The securitization process however was not backed by due diligence and led to large-scale default. The complexity of the instruments and the role of credit rating agencies played a contributory role. The high ratings assigned to certain CDO tranches, which were then quickly reversed with the onset of the crisis, created a panic situation among investors and precipitated the crisis.
While the initial effect of the crisis was profound on the US financial institutions and to a lesser extent on European institutions, the effect on emerging economies was less serious. In the initial stages, the capital flows to the emerging economies actually increased, giving rise to what is termed as positive shock and the decoupling debate. In the case of India , for example, the net FII flows during the five-month period from September 2007 to January 2008 was US$ 22.5 billion as against an inflow of US$ 11.8 billion during April-July 2007, which were the four months immediately preceding the onset of crisis.
The effect of the financial crisis on emerging economies thereafter was mainly through reversal of portfolio flows due to unwinding of stock positions by FIIs to replenish cash balances abroad. Withdrawal of FII investment led to stock market crash in many emerging economies and decline in the value of local currency vis--vis US dollar as a result of supply-demand imbalances in domestic markets. In the case of India, the extent of reversal of capital flows was US$ 15.8 billion during five months (February-June , 2008) following the end of positive shock period in January 2008.
Following the collapse of Lehman Brothers in mid-September 2008, there was a full-blown meltdown of the global financial markets. It created a crisis of confidence that led to the seizure of interbank market and had trickle-down effect on trade financing in the emerging economies. Together with slackening global demand and declining commodity prices, it led to fall in exports, thereby transmitting financial sector crisis to the real economy. Countries with export-led model of growth, as in many South- East Asian countries, and that depended upon commodity exports, were more severely affected. The impact on Indian economy was less severe because of lower dependence of the economy on export markets and the fact that a sizeable contribution to GDP is from domestic sources. Indias trade reforms since 1991 have moved progressively towards a neutral regime for exports and imports, eschewing tax and other incentives for exports.
The direct impact of the crisis on financial sector was primarily through exposure to the toxic financial assets and the linkages with the money and foreign exchange markets. Indian banks however had very limited exposure to the US mortgage market, directly or through derivatives, and to the failed and stressed international financial institutions. The deepening of the global crisis and subsequent deleveraging and risk aversion however affected the Indian economy leading to slowing of growth momentum.

FISCAL SUSTAINABILITY AND TAX SIMPLIFICATION



FRBM-2 :

Examine the possibility of a new target of zero fiscal deficit on a cyclically adjusted basis.

Reform

of Petroleum (LPG, kerosene), fertilizer and food subsidies to reduce leakages and ensure targeting, so that all the needy get the intended benefit. Limit LPG subsidy to a maximum of 6-8 cylinders per annum per household. Phase out Kerosene supply-subsidy by ensuring that every rural household (without electricity and LPG connection) has a solar cooker and solar lantern.

Convert

fertilizer subsidy from a partproducer subsidy to a wholly farmer-user nutrient related subsidy, with freedom to producers to set prices of formulations with different mix of neutrients.

Auction

3G spectrum. The auctioned spectrum must be freely tradable, with capital gains on spectrum to be taxed under the Income Tax Act.

Revitalize

the disinvestment program and plan to generate at least Rs. 25,000 crore per year. Complete the process of selling of 5- 10 per centequity in previously identified profit making non-navratnas . List all unlisted public sector enterprises and sell a minimum of 10 per cent of equity to the public. Auction all loss making PSUs that cannot be revived. For those in which net worth is zero, allow negative bidding in the form of debt write-off .

Introduction

of the new Income Tax Code, that results in a neutral corporate tax regime.

Rationalize

Dividend Distribution Tax to ensure full single taxation of returns to capital in the hands of the receiver (i.e. neither double taxation nor zero effective taxation).

Review

and phasing out of surcharges, cesses and transaction taxes (such as commodities transaction tax, securities transaction tax and Fringe Benefit Tax). Incentivise states to do the same with respect to stamp duties.

Revise

specific duties in the textile sector to ensure that they approximate a similar ad valorem rate as originally intended. Reduce these gradually that they do not exceed 30 per cent ad valorem. Convert them to ad valorem rate once WTO negotiations are concluded.

Review

customs duty exemptions and move to a uniform duty structure to eliminated inverted duties.

Implementation

of GST from April 1, 2010 to be done in way to ensure long run fiscal sustainability.

National

ID card based on unique identification number. Rapid operationalization of the UID authority (3 months), issue of UID to all residents (6 months) and creation of an integrated data base of information on all actual and potential beneficiaries of government programmes, subsidies and transfers (one year). A Household ID (HHID) could be created simultaneously or in parallel by linking it to a set of UIDs of individuals constituting the household. These IDs will form the base of a multiapplication smart cards (MASC) system that can be used to empower the poor and insure that they get the full benefits of all programmes such as NREGA, PDS, publically provided education, skill development, health services, social security (to persons at special risk), fertilizer subsidy, solar lanterns, solar cookers, etc.

Convergence

of plan schemes with focus on outcomes. Thrust on quality of expenditure and systems of monitoring andevaluation to improve the productivity of public expenditure.

FINANCIAL MARKETS



FUNDS FOR DYNAMIC ENTREPRENEURS



Passage

of the Banking Regulations (Amendment) Bill, 2005.

Lift

the remaining ban on futures contracts to restore price discovery and price risk-management .

Bring

all financial market regulations under SEBI with a view to encourage integrated development. Broaden the longterm debt market by liberalizing the investment norms of insurance and pension funds and development of credit enhancement institutions. Government can consider a guarantee mechanism (fund) for credit enhancement of long-term infrastructure debt. Tax incentives for long-term debt markets can be considered.

Liberalize

and develop spot and futures currency markets (exchange traded). Raise position limits for domestic companies and allow trading in SDRs and SDR currencies.

Introduce/allow

repos and derivatives in corporate debt. Introduce exchange traded interest rate derivatives, such as interest rate swaps (IRS).

Introduce

standardized credit default swaps that can be traded on exchanges, subject to stricter than normal limits on eligible participants.

Extend

spot commodity trading in electronic form to agricultural markets by involving APMCs.

Auction

rights to commercial borrowing within the already defined limits, with in-built (designed) preference for longterm borrowing. Auction of rights to invest in government securities by FIIs (under sub-limit of ECB) has already been successfully carried out.

High Net

Worth Individuals (HNIs) should be allowed to register and invest directly through authorized Indian investment intermediaries. This will allow ban of indirect ways of investment such as P notes.

Align

voting rights in banks with equity holdings. Allow public to hold greater equity in public sector banks within the policy of maintaining social control of management. Phased increase in FDI limits in banks and greater entry of foreign banks with tighter regulation of investing foreign banks and other foreign entities.

Allow

trading of directed credit obligations among banks and other financial institutions. This will allow and encourage the development of financial institutions that can specialize in and exploit economies of scale and scope in unbanked/ low banked areas and sectors.

Link

small savings rates to government debt instruments or bank deposit rates of similar maturity. Make responsive to depositcredit market conditions.