A V Rajwade: Two holy cows

Recent studies have discredited the focus on inflation targeting and fiscal deficit

Reports suggest that the gazette notification for the Consumer Price Index (CPI)-based inflation targeting regime and constitution of the monetary policy committee is likely to be issued shortly. Once sanctified, it is going to be very difficult to change, given that, "there are no full stops in India", as Mark Tully titled one of his books. To my mind, such single-minded focus on one variable could be an adverse influence not only on growth and employment creation, but also on the health of the banking system, particularly when, as currently, there is a wide divergence between the CPI and Wholesale Price Index (WPI), which is much more relevant to business margins.

The Bad Samaritans (title of a book by Ha-Joon Chang of Cambridge University) of the rich countries and the International Monetary Fund have consistently advised emerging economies of the virtues of price stability and low fiscal deficits. As I have argued in this column, on first principles, the demographics of an economy could be a very important determinant of inflation. I recently came across a column in The Economist (July 23) supporting my hunch. Research by a German bank based on 'dependency ratio' (the ratio of children and old people to people of working age) data of a selected group of countries over the last 70 years suggests that gross domestic product (GDP) and real per capita income grew faster in the years when the ratio was falling (that is, the working age population was increasing), than in the years when it was rising. Inflation also tends to be higher when the dependency ratio is falling and lower when it is rising. In other words, demographics are an important variable underlying inflation and growth. In our case, something like 12 million people are entering the job market each year. The sample of countries in the German research consisted of some of today's advanced economies, and it is perhaps time the Reserve Bank of India undertakes research on the issue.

Arguably, for an emerging economy, what is even more important is an exchange rate policy objective for the central bank than an inflation target: over the last 20-odd years, mismanaged exchange rates have been the cause of too many crises in emerging economies. On the other hand, I can think of only one example of hyper-inflation leading to a crisis in recent decades, namely Zimbabwe.

Coming to the other holy cow, fiscal deficit, is it leading to 'creative accounting'? Last week, there were reports (Financial Express, July 29) as to how the State Bank of India was asked to pay a fictitious tax demand of Rs 10,000 crore on March 31 - on the promise that this will be refunded after two days. Clearly, this was an effort to increase revenue in one year, at the cost of next year's revenue. While this case has been reported, surely it is not unique. Another mechanism to control fiscal deficit is to get "independent" entities like the National Highways Authority of India, Indian Railway Finance Corporation, etc., to borrow in their names. Surely, these are costlier government borrowings, except in name? The finance minister is now looking at a "makeover" of the preparation and presentation of the Budget from the next financial year, focussing on scrapping the Plan/non-Plan expenditure, and separation of the expenditure side into establishment and obligatory expenditures, central sector schemes, and transfers to states.

While this is welcome as far as it goes, perhaps he needs to look at whether deficits arising from capital expenditure need to be treated differently. Recently, Martin Wolf, the Financial Times columnist, in an article (April 15) emphasised the need to make a "distinction between current and capital spending", since the latter creates assets. Noah Smith, professor of Finance at Stony Brook University and also a Bloomberg columnist, in a recent article (Mint, June 14) quotes a number of researches who seem to overturn the accepted wisdom that:

• High public debt causes low growth;
   
• The fiscal multiplier, which measures the impact of changes in fiscal deficits on the ratio of public debt to nominal GDP, is 0.5 - it is actually much higher;
   
• That public investment 'crowds out' more efficient private investment; etc.

Clearly, the advice of 'Bad Samaritans' needs to be taken with a big pinch of salt!

avrajwade@gmail.com