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The Southern India Mills’ Association

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Sustaining high growth with low inflation

If supply-side polices successfully reduce costs and inflation, macroeconomic policy can afford to be stimulatory
The key issue facing India is how to sustain high growth with low inflation. Its post reform growth has been volatile, and aborted by episodes of high inflation. A useful way to think about the problem is to understand how despite Indian output being below potential, as large numbers enter the labour force, it is still running a current account deficit (CAD) in the balance of payments. India is inside its production possibility frontier yet demand is greater than what it can produce domestically.
If bottlenecks in specific sectors limit production and exports, there can be unutilised capacity together with demand that spills over into a CAD. China, a similarly large country with surplus labour, was also inside its production possibility frontier. Under-valuation of its currency aided an expansion in production of traded goods and of exports that absorbed underemployed labour.
India, however, is dependent on primary energy imports. Depreciation in order to increase exports can raise the import bill and inflation. A big advantage for China was it started its catch-up growth in 1978 with reform that raised agricultural productivity. Low relative food prices are essential for sustained low-inflation growth in populous countries where food has a large share in the consumption basket. Major intermediate commodity imports, such as oil, also contribute to inflation.
China used to export oil but became a net oil importer in 1993. By 2006 it imported 47 per cent of its consumption, and by 2013 became the largest oil importing country. But by then its exports had grown enough to finance imports without materially reducing its current account surplus.
China started its reforms process with a very low share of oil imports, but in India this was high to begin with. India is the third largest oil importer. In 2009-10, crude oil imports amounted to 80 per cent of its domestic crude oil consumption and 31 per cent of its total exports compared to 14 per cent for China.
India’s dependence on commodity imports implies limiting depreciation would help contain inflation. A real appreciation may help keep traded goods such as oil and food cheaper. Then on its growth path consumption of both traded and non-traded goods rises but production shifts relatively more towards non-traded goods, as their relative prices rises. India has seen higher inflation in non-traded services such as health and education. Even so, exports have to expand in sectors with potential. India’s outsourcing and other service exports helped finance its oil imports.
Even if there is a CAD, better utilisation of resources and expansion of capacity in export sectors may eliminate it without having to reduce aggregate demand. A CAD also implies investment exceeds domestic savings. Financial savings largely fund investments involving goods that are tradeable, while physical savings are invested more in non-traded goods, such as in real estate.
Estimates of physical savings in the household sector are identical to those of investment in the unorganised sector. It follows, then, that if organised sector investment exceeds financial savings, it will have to be financed by foreign savings that is, by running a CAD. In recent years although the savings-GDP ratio has fallen to about 30 as growth slowed, it is household physical savings that have fallen, while household financial savings have recovered from a low of 8 per cent in 2011-12. Savings of non-financial corporations that are held in financial assets have risen. Thus better financial intermediation of domestic savings also reduces the CAD and dependence on volatile foreign capital inflows.
Alleviation of constraints
Constraints in agriculture have been a major factor limiting India’s growth. For example, high food inflation triggered macroeconomic tightening and reduced growth after 2011. A large number of subsidies and price distortions were not able to adequately improve food production.
By 2018, however, India seems to have entered a period of structural agricultural surpluses. World political economy also seems to be working to keep oil prices in the $60-70 range, which suits both oil importing and exporting countries, since it maintains future oil supplies thus reducing volatility. Moreover, with better pass through of oil prices, India’s oil intensity has been falling since 2005.
Constraints are being removed but even so specific competitive sectors must be encouraged for the export expansion required to cover the oil import bill, which remains large.
Supply side policies
A constant or mildly appreciating real exchange rate has to be accompanied by focused sectoral and general supply-side measures to improve exports. The WTO bans industry specific subsidies as trade distorting, but developing and LDCs, with per capita incomes of $1000 (in constant US 1990 $) are allowed exemptions. India crossed the threshold in 2017. Therefore its support to traded goods sectors needs to be delivered in ways that do not distort prices.
Targeted and limited direct benefit transfers to farmers, along with measures to improve productivity and marketing are all steps in the right direction. Allowing stable exports in organic and processed foods will also help farmers get better price realisation. It will not be inflationary since world food prices are also likely to remain soft.
Despite the Central and State governments provinding over 60 different types of subsidies to textile exporters, there are complaints about delays and distortions. The government should therefore, in consultation with exporters, shift to other supporting policies some of which can specially benefit textiles and other export intensive sectors. These include export infrastructure, logistics, skilling, technology development and ease of doing business some of which is happening.
General supply-side measures must focus on building capacity to participate in higher growth and on reducing costs. The current collapse in inflation is partly due to the success of such measures, in addition to the softening of oil prices. For example, GST has reduced transportation and logistics costs for companies, as well as many indirect tax rates.
Demand side policies
If supply-side polices successfully reduce costs and inflation, macroeconomic policy can afford to be stimulatory. Indian catch-up growth was unnecessarily volatile because neglect of critical bottlenecks made supply and external shocks relatively large, while policy rather than smoothing shocks tended to over-react to them.
Inappropriate policies arose from incorrect macroeconomic stabilisation understanding. In a populous country with underemployed labour, sectoral bottlenecks and price shocks can cause inflation even without aggregate excess demand. On the Indian growth path, therefore, as long as focused sectoral and general supply-side measures improve exports and reduce costs, macroeconomic policies have space to stimulate growth and the absorption of under-employed labour. Such stimulus can be effective.
The current structural view on fiscal consolidation as well as pressure from foreign investors reduces fiscal space, puts the onus on monetary policy to stimulate the economy in the current slowdown. As tax collections fall in a slowdown, a mild rise in fiscal deficits is an automatic stabiliser and should be welcomed.