Tag: Vijay Joshi | Page 2

19 July, 2016

Why Inflation Cannot Be a Growth Strategy

In the recent past it has been suggested that some amount of inflation cannot be bad in order to get economic growth going again. Hence, the Reserve Bank of India(RBI), should cut the repo rate in order to get the economic growth going.

Repo rate is the rate at which RBI lends to banks. The hope is that when the RBI cuts the repo rate, banks will also cut their lending rates. At lower rates both individual consumers as well as firms will borrow and spend more. And this will get economic growth going again. (As I have said in the past individual consumers are already borrowing at a record pace even at the so called high interest rates).

How does this work? As RBI governor Raghuram Rajan had explained in a February 2014 speech: “By raising interest rates, the RBI causes banks to raise rates and thus lowers demand; firms do not borrow as much to invest when rates are higher and individuals stop buying durable goods against credit and, instead, turn to save. Lower demand growth leads to a better match between demand and supply, and thus lower inflation for the goods being produced, but also lower growth.”

When RBI cuts the repo rate this trend reverses. As Rajan explained: “Relatedly, if lower rates generate higher demand and higher inflation, people may produce more believing that they are getting more revenues, not realizing that high inflation reduces what they can buy out of the revenues. Following the saying, “You can fool all the people some of the time”, bursts of inflation can generate growth for some time. Thus in the short run, the argument goes, higher inflation leads to higher growth.”

The trouble is that this inflation eventually catches up with growth. As Rajan said: “As the public gets used to the higher level of inflation, the only way to fool the public again is to generate yet higher inflation. The result is an inflationary spiral which creates tremendous costs for the public.”

Hence, it is important that inflation stays in control, if a country is looking for strong growth over a long period of time. (As I had explained in a column last week).

Inflation as per the consumer price index has started to go up again. For June 2016, the inflation was at 5.77 per cent. In comparison, the inflation in June 2015 was at 5.40 per cent. One reason for this jump has been food inflation. Food inflation in June 2016 was at 7.79 per cent. Within food, vegetables, pulses and sugar, saw an increase in price of 12.72 per cent, 28.28 per cent and 12.98 per cent, respectively. Spices went up by 8.13 per cent. Food items constitute 54.18 per cent of the consumer price index. Food inflation impacts poor the most given that a bulk of their income goes towards paying for food.

As is obvious, the jump in inflation as per consumer price index has been due to a rise in food inflation. The RBI cannot do anything about food prices through the repo rate, and hence, the RBI should cut the repo rate, or so goes the argument.

In the 2014 speech Rajan had explained this by saying: “I want to present one more issue that has many commentators exercised – they say the real problem is food inflation, how do you expect to bring it down through the policy rate? The simple answer to such critics is that core CPI inflation, which excludes food and energy, has also been very high, reflecting the high inflation in services. Bringing that down is centrally within the RBI’s ambit.”

So RBI cannot control food inflation but it can control the prices of other items that make up the consumer price index, through its monetary policy. In fact, the RBI can control, what economists call the “second round effects”.

Economist Vijay Joshi explains this in his new book India’s Long Road—The Search for Prosperity: “What sparks inflation is quite different from what keeps it on the boil. Though a supply shock raises the price of, say, food or oil products, this leads to a persistent rise in the overall price level only if it spreads and gathers strength due to the pressure of aggregate demand. If the economy is ‘overheated’, the inflation impulse becomes too generalized. A wage-price spiral can then develop that is hard to break, especially if people begin to expect higher inflation and increase their wage and salary claims in order to protect their real incomes.”

And this is where monetary policy and the central bank come in. As Joshi writes: “To prevent these ‘second-round effects’, monetary policy has to keep excess demand and inflationary expectations under check.”

Hence, while the RBI cannot control food prices, its monetary policy can have an impact on other elements that constitute the consumer price index. And this explains why the core-inflation (prices of products other than food and fuel) in June 2016 cooled to down 4.5 per cent. It was at 4.7 per cent in May 2016. This, despite the fact that food inflation is close to 8 per cent.

In fact, Rajan explained this beautifully in a June 2016 speech where he said: “The reality is that while it is hard for us to control food demand, especially of essential foods, and only the government can influence food supply through effective management, we can control demand for other, more discretionary, items in the consumption basket through tighter monetary policy. To prevent sustained food inflation from becoming generalized inflation through higher wage increases, we have to reduce inflation in other items. Indeed, overall headline inflation may have stayed below 6 percent recently even in periods of high food inflation, precisely because other components of the CPI basket such as “clothing and footwear” are inflating more slowly.”

Given that this is not such a straightforward point to understand, many people fall for the inflation is good for growth and that RBI cannot control inflation, arguments.

The column originally appeared in Vivek Kaul’s Diary on July 19, 2016

14 July, 2016

The Modi Govt is Finally Unleashing the Power of Executive Action

Any stock market survives on two things—hope and stories.

Sometimes both hope and stories run parallelly.

Sometimes the stories run out and hope takes over. Sometimes the hope runs out and the stories take over.

When Narendra Modi was elected as the prime minister of India in May 2014, there was great hope among stock market investors that he would unleash a new wave of economic reform that would fast-forward the economic reforms process started in 1991.

But nothing of that sort happened. As economist Vijay Joshi writes in India’s Long Road—The Search for Prosperity: “There can be little doubt that the Partial Reform Model has left India unprepared.”

The country is unprepared to take on the challenges that lie ahead, the biggest among them being the fact that nearly one million individuals will enter the workforce every month, over the next decade and a half.

For the stock market investors, the story did not turn out the way it was expected to. Initially, they went back to hoping that some economic reforms will be initiated. When that did not turn out to be the case, they found another story to explain to themselves, and anyone else who was ready to listen, why things hadn’t turned out as expected.

This time the story was that the Modi government did not have majority in the Rajya Sabha and given this, the Congress party was in a position to block key legislation, which they did. What they forgot to tell us was that the Bhartiya Janata Party had behaved along similar lines in the past when it was in the opposition.

As Joshi writes: “Lack of a majority in the Rajya Sabha is also not a completely new problem: other governments in the past have faced it quite successfully by using their negotiating skills. It was therefore widely expected that the new government would undertake a programme of sweeping economic reform.” Nevertheless that did not happen.

Also, every reform does not need a legislation. As Joshi puts it: “Quite a lot can be done without new legislation, simply on the basis of ‘executive action’.” An executive action of the government unlike a new legislation does not need the approval of the Parliament.

The Modi government has started to unleash the power of executive action in the recent past and that is a good thing. Here are a few things that it has done in the recent past and plans to do in the days to come, which should work well for the Indian economy.

a) Starting this month, the government has allowed oil marketing companies to increase kerosene prices by 25 paisa every month, up until April 2017. This will result in a saving of Rs 2.25 per litre (25 paisa multiplied by nine months) of kerosene sold during the current financial year.

The strategy is similar to the previous Congress led United Progressive Alliance government allowing the oil marketing companies to increase the price of diesel by 50 paisa every month. It was ultimately this strategy which helped the Modi government to deregulate diesel in October 2014.

The under-recovery on diesel for the month of July 2016 stands at Rs 13.12 per litre. The Bank of America-Merrill Lynch expects that this gradual increase in prices will lead to savings of Rs 1,100 crore for the government during this financial year. If the price increase continues in 2017-2018 as well, then the government will see savings of another Rs 2,400 crore.

While this is not a huge amount, it is a step in the right direction. Also, it needs to be pointed out here that 46 per cent of kerosene distributed through the public distribution system does not reach those it is intended for. The leakage into the open market is used to adulterate diesel and is also smuggled into neighbouring countries.

b) In June, the government had introduced some reforms in the textile sector through executive action. The government re-introduced the concept of a fixed term contract which allows textile companies to hire workers for a fixed period, instead of offering permanent employment.

Up until now companies had been hiring contract workers, who in many cases are not paid as much as permanent workers are, even though the work being done is exactly the same. The fixed term contracts will also allow companies the flexibility to hire according to their demand. And they won’t have to keep workers on the rolls even when they don’t actually need them.

This should help create employment in the low-skilled workers space, which is India’s natural competitive advantage and that is precisely what India wants. (You can read the complete article here).

c) Another good decision is the government’s move to invite merchant bankers to sell shares of 51 companies that it holds through the Specified Undertaking of Unit Trust of India(SUUTI). The SUUTI was formed in 2003 to bailout the investors of US-64, the flagship scheme of the UTI.

The government owns companies like ITC, Axis Bank and L&T, through SUUTI. And it’s time the government sold these shares to raise some money. Also, it is important how this money is used. Instead of simply going into the general coffers of the government, it should be specifically earmarked towards creating better physical infrastructure.

In fact, as I write this, there is a report in the Mint which suggests that the government will get the Life Insurance Corporation of India to pick up a major portion of the shares held by SUUTI. The Mint quotes an official as saying: “LIC has been asked to pick up at least a third of the overall SUUTI holdings. This primarily includes (its holdings in) ITC, Axis Bank and L&T. The cost of the deal could be Rs 25,000-30,000 crore for LIC.”

If anything of this sort happens this will dilute the entire idea of the government selling out shares held by SUUTI, lock, stock and barrel. Basically money will move from one arm of the government to another. It is estimated that the current value of shares held by SUUTI is around Rs 60,000 crore.

d) A news report in the Swarajya Mag suggests that the NITI Aayog has recommended that “as many as 16 PSUs” be put up for strategic sale and 26 others be closed down. If the government does get around to doing this, it will be a huge thing. A lot of money that is currently being wasted will no longer be wasted. The loss making public sector enterprises lost more than Rs 27,000 crore in 2014-2015.

Other than money being saved, it will also give the government more bandwidth to concentrate on more important things than looking after loss making public sector enterprises.

The column originally appeared in Vivek Kaul’s Diary on July 14, 2016

12 July, 2016

Mr Stiglitz, India’s Obsession with Inflation is Correct

Joseph Stiglitz, a Nobel prize winning economist, had some advice for Indian policymakers last week. Speaking in Bangalore, Stiglitz said: “Excessive focus on inflation almost inevitability leads to higher unemployment levels and lower growth and therefore more inequality.”

The point that Stiglitz was making is that the government of India should spend more than it currently plans to. Further, the Reserve Bank of India(RBI) should cut interest rates further and encourage people to borrow and spend more. Of course, all this extra spending will lead to some inflation, with more money chasing the same quantity of goods and services. But that will be a small price to pay for economic growth. This economic growth will lead to lower unemployment and in the process lower inequality.

This is precisely the kind of argument that was made during the Congress led United Progressive Alliance(UPA) regime, to justify the high rate of inflation that prevailed between 2008-2009 and 2013-2014.

The trouble is that there is enough evidence that suggests otherwise. Over the last five to six decades, countries which have grown at a very fast pace, have had very low rates of inflation.

As Ruchir Sharma writes in The Rise and Fall of Nations—Ten Rules of Change in the Post-Crisis World: “The miracle economies like South Korea, Taiwan, Singapore, and China, which saw booms, lasting three decades or more, rarely saw inflation accelerate to a pace faster than the emerging market average. Singapore’s boom lasted from 1961 to 2002, and during that period inflation averaged less than 3 percent.”

The same is the case with China. As Sharma puts it: “In China, the double digit GDP growth of the last thirty years was accompanied by an average inflation of around 5 percent, including an average rate of around 2 percent over the decade ending in 2010. China saw a brief surge in inflation in 2011, and economic growth in the People’s Republic has been slumping steadily since then.”

The point is very clear, inflation is not good for economic growth. There is enough evidence going around to show that. The same can be said in the Indian case as well, when the inflation surged between 2008-2009 and 2013-2014. It ultimately led to economic growth collapsing.

Year	Inflation (in %)	Economic Growth (in %)
2007-2008	6.2	9.32
2008-2009	9.1	6.72
2009-2010	12.37	8.59
2010-2011	10.45	8.91
2011-2012	8.39	6.69
2012-2013	10.44	4.47
2013-2014	9.68	4.74

In 2007-2008, inflation was at 6.2 per cent and the economic growth came in at 9.32 per cent. In the aftermath of the financial crisis that started in 2008-2009, the union government increased its expenditure in the hope of ensuring that the economic growth did not collapse.

The government expenditure budgeted for 2008-2009 was at Rs 7,50,884 crore. The final expenditure for the year was at Rs 8,83,956 crore, which was around 17.8 per cent higher. The expansive fiscal policy led to inflation, which in turn led to lower economic growth in the years to come.

The increased government spending led to high inflation in the years 2009-2010 and 2010-2011, but at the same time it also ensured that economic growth continued to stay strong in the aftermath of the financial crisis. Nevertheless, high inflation ultimately caught up with economic growth and it fell below 5 per cent during 2012-2013 and 2013-2014.

The point being that extra spending and lower interest rates leading to inflation might help bump up economic growth in the short-term, but over the longer term it clearly does not help. What made the situation even worse was that RBI did not get around to raising interest rates as fast as it should have.

As Vijay Joshi writes in India’s Long Road—The Search for Prosperity: “Since fiscal policy was expansive, the job of demand-side inflation control was left to the RBI. Given the strength of both demand and cost-push forces, monetary policy would have had to be tough to be effective. Put bluntly, the RBI muffed it. It took a softly-softly approach to raising interest rates. While this may perhaps have been understandable because it feared hurting investment and growth, it is surely no surprise that inflation proved to be persistent.”

High inflation also leads to a situation where the household financial savings fall. This is precisely how things played out in India. Between 2005-2006 and 2007-2008, the average rate of household financial savings stood at 11.6 per cent of the GDP. In 2009-2010, it rose to 12 per cent of GDP. By 2011-2012, it had fallen to 7 per cent of the GDP. In 2014-2015, the ratio had improved a little to 7.5 per cent of GDP.

Household financial savings is essentially a term used to refer to the money invested by individuals in fixed deposits, small savings schemes of India Post, mutual funds, shares, insurance, provident and pension funds, etc. A major part of household financial savings in India is held in the form of bank fixed deposits and post office small savings schemes.

A fall in household financial savings happened because the real rate of return on deposits entered negative territory due to high inflation.

This led to a situation where savers have moved their savings away from deposits and into gold and real estate. As RBI governor Raghuram Rajan said in a June 2016 speech: “In the last decade, savers have experienced negative real rates over extended periods as CPI has exceeded deposit interest rates. This means that whatever interest they get has been more than wiped out by the erosion in their principal’s purchasing power due to inflation. Savers intuitively understand this, and had been shifting to investing in real assets like gold and real estate, and away from financial assets like deposits.”

If a programme like Make in India has to take off, low household financial savings cannot be possibly a good thing. This hasn’t created much problem in the recent past, simply because bank lending to industry has simply collapsed. Banks (in particular public sector banks) are not interested in lending to industry because industry has been responsible for a major portion of bad loans in the last few years.

But sooner or later, this situation is going to change. And then the low household financial savings ratio, will have a negative impact and push interest rates up. In this scenario, it is important that inflation continues to be under control and the real rates of return on deposits continue to be in positive territory. That is the only way, the household financial savings ratio is likely to go up.

As Joshi puts it: “In today’s world of low inflation, India’s long-run inflation target should certainly be no higher than 4 or 5 per cent a year.” And that is something both the RBI as well as the union government should work towards achieving and maintaining.

The column originally appeared in Vivek Kaul’s Diary on July 12, 2016

8 July, 2016

What the Govt Should Do and What It Shouldn’t

The government of India over the years, at least in theory, has tried to make the lives of its citizens comfortable, by trying to deliver various goods and services at a subsidised rate.

And it has failed miserably at it. The leakage is extremely high i.e. much of the stuff the government wants to deliver gets stolen before it reaches the individuals it is meant for.

54% of the wheat that the government distributes through the public distribution system gets siphoned off. So does 15% of the rice and 48% of the sugar.

And the stealing doesn’t end at rice and wheat. 40% of fertilizer, 46% of kerosene and 24% of cooking gas is also stolen.

The government suffers from what economists call a principal-agent problem. As Vijay Joshi writes in India’s Long Road—The Search for Prosperity: “The government…suffers from a ‘principal-agent problem’. Its functionaries (legislators, bureaucrats) may pursue their own agendas rather than act in the public interest. They may shirk their duties or feather their own nests.”

While politicians and high-level bureaucrats are a part of the government, they are not the ones that people of this country deal with on a regular basis. The people deal with low level officials, from clerks at the local transport authority who won’t lift a finger without being bribed to the shopkeepers running the public distribution system, throughout the country.

And the incentives of these individuals are not in line with the public interest. Hence, there is pilferage and the subsidies that are meant for the people of this country never reach them.

This leads to a lot of money being spent by the government getting wasted. It leads to the government having to incur a higher expenditure than it would have if things reached the people they were meant for.

It also leads to an active black economy, where everything that is stolen from the public distribution system, is sold in the open market, at a higher price.

So what is the way around this? Should the government stop subsidising the people of this country and in the process save the money that gets wasted? Not really.

As Joshi writes: “There is a crucial distinction to be made between on the one hand the state paying for goods and services and on the other hand the state producing goods and services. For example, ‘food security’ may be thought of in common usage as a ‘public good’. However, even if it is agreed that the state should pay for food security, it does not follow that the state should carry out the task of actually delivering food to people.”

The fact that the government tries to deliver rice, wheat, sugar, kerosene, cooking gas, etc., to people, leads to the principle-agent problem and all the corruption that follows. So what is the way out? As Joshi writes: “The state could enable the poor to buy food in the market, at market prices, by transferring purchasing power to them directly in the form of cash or food vouchers. A system along these lines may be more effective in reaching poor people, and also less corrupt. This example is not chosen at random: it is highly relevant to the problems facing India’s public distribution system(PDS) for food delivery.”

Such a system is already available in case of cooking gas. It’s called Pahal. In this case, the subsidy amount on a cooking gas cylinder is paid directly into the bank account of the individual, instead of the cylinder being sold at a lower subsidised price, as was the case earlier.

In late June, 2016, the finance secretary Ashok Lavasa, told PTI that the government had saved Rs 14,872 crore by paying the subsidy amount directly into the account of people, instead of trying to deliver the cooking gas cylinder at a subsidised amount. The government has been able to save money by being able to bring down the cooking gas cylinders being sold in black.

As the Economic Survey of 2015-2016 points out: “The Pahal scheme has been a big success. The use of Aadhaar has made black marketing harder, and LPG leakages have reduced by about 24 per cent with limited exclusion of genuine beneficiaries.”

The real benefit to the government and the citizens will come when the government is able to implement the cash transfer programme (or what it calls direct benefit transfer) to other areas, where the leakages are high. For this to happen, citizens need to have Aadhaar cards and these cards need to be linked to savings bank accounts.

A lot of progress has been made in the issuance of Aadhar cards. As the Economic Survey points out: “The current government has built on the previous government’s support for the Aadhaar program: 210 million Aadhaar cards were created in 2015, at an astonishing rate of over 4 million cards per week. 975 million individuals now hold an Aadhaar card – over 75 percent of the population and nearly 95 per cent of the adult population.”

An Aadhaar card is necessary in order to identify the right beneficiary. This helps in eliminating bogus identities, through which people claim subsidies. But for the government to be able to transfer money to individuals, the Aadhaar card needs to be linked to a bank account.

As of June 2016, the 22.3 crore bank accounts had been opened under the Jan Dhan Yojana. This is a huge jump from 5.3 crore bank accounts from September 2014. Nevertheless, a lot still needs to be done on this front. As the Economic Survey points out: “Despite Jan Dhan’s record-breaking feats, basic savings account penetration in most states is still relatively low – 46 per cent on average and above 75 per cent in only 2 states (Madhya Pradesh and Chattisgarh).”

The Economic Survey was published in February 2016. Given that some time has elapsed since then, the figures quote above would have improved since then. What also does not help is the fact that only 27 per cent of villages have a bank within a distance of 5 kilometres. This means that last mile connectivity is a problem.

This essentially means that if the government moves to cash transfers immediately in a whole host of areas, chances of people being left out because they do not have a bank account, are high. This needs to be set right in the years to come. Of course, it is easier said than done.

The savings from such a system, if and when it is in place, will be huge. As Nitin Gadkari, the road transport and highways minister recently said: “If bogus claims are removed from scholarships, pension, subsidies, ration cards and other schemes and these are linked to Jan Dhan Yojna and Aadhar, it will result in savings of Rs 1 lakh crore to the exchequer.” For all the leakages that happen, Gadkari might just be right.

The column originally appeared in Vivek Kaul’s Diary on July 8, 2016