For a long time, the government maintained that inflation was a price the country had to pay for high growth. Over the last few months, economists have debated whether high inflation should become the new normal. But most of these theories are now coming to nought, since inflation has now become the dominant theme. Chetan Ahya, managing director of Morgan Stanley, Research, in an interview with Malini Bhupta, explains the causes behind India’s high inflation and what the Indian government needs to do about it. Excerpts:
What are the key macroeconomic challenges that India faces at present?
The first issue is inflation, which has been widely discussed. The government is now rightly working on reversing fiscal and monetary stimulus to manage the inflation pressure. Though this may result in some sacrifice of growth in the near term, controlling inflation is more important for society's welfare.
The second issue is the pace of investments in India. There is a slowdown in the order book position of engineering and construction companies. It picked up as global growth started to pick up but in the third quarter of 2010, it started to slow again. We are expecting March figures soon, but initial indications suggest the recovery will be weak.
If you cannot lift the investment-to- GDP ratio, your potential growth will not rise. We have been forced to lower growth owing to higher inflation. In the aftermath of the global financial crisis, governments tried to stimulate domestic demand by increasing expenditure. This initially helped revive growth and confidence in the economy. But the support of the government has continued long enough. By mid-2009, the government should have reversed the expenditure-to-GDP ratio and taken measures to revive private investment sentiment.
However, in this period the European Union’s sovereign debt crisis occurred, which, coupled with soaring commodity prices and a spate of graft cases, affected investment sentiment. Against this background, the government needs to take measures that will attract investment. The government can consider measures like opening up foreign direct investment in retail and announce some large infrastructure projects in key cities across India. The government can put these projects up for transparent bidding and ensure the projects are cleared. There is a need for a campaign-style effort to revive corporate sector sentiment.
In the medium term, we need to boost the investment-to-GDP ratio. If it’s not kick-started, we will have to live with lower growth to avoid inflation risks. We need to ensure the economy gets out of this weak investment phase fast, for which the government needs to take measures. This will require determination.
Do you think monetary policy intervention can address high inflation?
Let’s first understand what has caused inflation pressures. At the heart of this inflation problem in India has been the government’s fiscal policy. As soon as it was evident that the world was not as bad a shape as many thought in the last quarter of 2008, a quick reversal of the government expenditure-to-GDP ratio should have happened. However, government spending remained high for longer at a time when a credit crisis meant that the private investments would suffer. The government spending boosted consumption and capacity creation suffered, causing inflation. In addition to this, we experienced supply shocks in the form of higher food and global commodity prices exacerbating the inflation problem. Although, inflation may have arisen owing to fiscal policy and supply shocks, monetary policy still has a role to play to ensure inflation does not become vicious. If interest rates do not rise in line with inflation, low real interest rates will negatively impact society’s behaviour and distort resource allocation. Households will be disincentivised to save and encouraged to borrow. The supply chain of producers and traders is also distorted. This behaviour can make the inflation problem vicious.
At the start of this calendar year, a rise in crude oil prices was a major cause of concern. With crude oil prices cooling in the past few days, does the concern remain for India?
The US is perceived to have exported inflation to the rest of the world by injecting liquidity into the system through its loose monetary policy and quantitative easing (QE) programmes. For inflation to come off, easy liquidity needs to reverse. What is your view on that?
I don’t think there’s a direct link between QE2 and commodity prices. Right after the financial crisis in 2008, developed as well as emerging economies initiated a major drive to push government expenditure to GDP higher. Developed world economies are running large fiscal deficits. Emerging economies have pursued loose monetary and fiscal policies to push domestic demand, since they were concerned about the negative impact of the weak growth in exports. However, the global recovery came through much faster than expected. In Asia, both China and India had a similar approach. India lifted government expenditure to GDP growth by 4 per cent of GDP and China disbursed $3.4 trillion loans to the banking system. A stronger global growth fuelled demand for commodities when supply was tight. However, the productivity dynamic has been weak in the initial period of recovery. There was wasteful aggression in boosting growth, since governments did not wish to live with low growth. India, too, increased government expenditure without thinking whether it was going into productive activities resulting in inflation pressures. This is clearly not sustainable.
Do you believe there will be a third round of quantitative easing?
Our house view is that there will be a gradual policy exit in the US from here. We continue to look for the Fed to stop buying in June, stop reinvesting in August or September, start draining sometime in Q4, and raise the interest rate on banks’ reserves with the central bank in early 2012. We expect the job market to improve. After boosting productivity in the initial phase, new jobs will gradually pick up.
There seems to be much talk about high inflation becoming the new normal. Do you agree with this?
High inflation cannot be the new normal. High inflation is not good. Surely higher GDP growth helps bring welfare to the society but if it is accompanied by a major rise in inflation, it results in net welfare loss to the society. Higher inflation results in an unfair burden on poorer sections of the economy. The government is unlikely to accept high inflation since Indian society has been anchored to an inflation rate of 5 to 5.5 per cent.
How will the graft cases impact India's ability to attract investments?
We do not think these investigations have had any major impact on foreign investor sentiment. Most investors understand that these risks exists in emerging markets. However, it is important for India to use this development as an opportunity to strengthen the institutional capability, to minimise such risks.