Mritiunjoy Mohanty


The economy is in a deep hole but one would not get that sense from reading the budget or the accompanying Economic Survey. Indeed quite the opposite. The Government seems to suggest that the growth deceleration that economy has witnessed over the last three years has bottomed out and that 2014/15 should see a resumption of the upward growth curve. It is estimated that in 2014/15 GDP growth will be in the range of 5.4-5.9% as opposed to less than 5% in the preceding two years.  The current account deficit has seen a sharp improvement from 4.7% in 2012/13 to 1.7% in 2013/14 and finally inflation has decelerated as well.  The Finance Minister has taken the slow and steady route and will introduce more reforms that will get the economy back to 7-8% growth in the medium term.


There is little discussion of the fact that gross fixed capital formation which had been one of the most important drivers of the preceding boom and had seen a sharp deceleration actually contracted by 0.11% in 2013/14 after growing at only 0.78% in the preceding year. All available evidence would suggest that the investment slowdown is largely due to the behavior of private corporate investment. What little discussion there is ascribes the slowdown in private corporate investment to a high fiscal deficit which pre-empts resources that otherwise would have been available to the private sector and policy paralysis. Therefore lowering the fiscal deficit is seen to be of primary importance alongside unblocking large infrastructure projects caught in a policy logjam.


But this view of the world is an almost willful misunderstanding of both the causes of the current account crisis and inflation.  Because along with a worsening current account, post 2008/09 inflation entered a new phase, attaining levels much higher than the eight-year period prior. Not only did inflation attain higher levels but prices also turned sticky with inflation slowing down much more slowly even as  economic growth cooled rapidly. Over the period of the current economic slowdown CPI and WPI behavior has diverged with CPI continuing to rise rapidly even as WPI slows down somewhat. The current account deficit is seen to be the result of oil and gold imports and inflation the result of real wage driven demand increases and supply-side shocks.


Over the last two decades the India’s economy has seen substantial integration with the global economy. Total trade in goods and services as a percentage of GDP stood at 20.2% for the period 1992/93-1996/97. This rose to 39.7% for the period 2003/04-2007/08 and then again to 50.6% for the period 2008/09-2011/12. Impressive as this, import integration in goods has grown even faster, rising from an average of 9% between 1992/93-1996/97 to 23.3% over the period 2008/09-2011/12. It stood at 26.4% for the period 2011/12-2012/13. While increase in oil imports explain some of this, there has been a substantial increase in non-oil non-gold (and silver) imports as well – the ratio more than doubles going from 6.8 to 13.9% over the same period. In sum, India is substantially more integrated into the global economy today as compared with the mid-1990s and imports of goods and oil has been an important driver of that integration.


In terms of macroeconomic performance, the low and the high inflation – 2001-2007/8 and 2008/9-2012/13 respectively -are quite different. Over the low inflation period as growth accelerates, inflation remains subdued, current account deficits are small, gross fiscal deficits decline and there is a surplus in the primary revenue account of the budget.


This benign story almost completely reverses itself during the high inflation phase. Between 2008/9-2010/11 the economy rebounds from the global financial crisis and attains high growth again but macroeconomic fundamentals have worsened: inflation is appreciably higher; both the current account deficit and the gross fiscal deficit increase significantly; and finally the budget has a primary revenue deficit. Over the period 2011/12-2012/13 there is a sharp deceleration in growth but a sharp acceleration in CPI-IW inflation even as WPI inflation moderates a little but remains high. Other macroeconomic fundamentals worsen even further: the current account deficit almost doubles on the back an import surge and export slowdown; the gross fiscal deficit remains elevated alongside a primary revenue deficit. It is also worth noting that the when compared with the 1990s levels of gross fiscal deficit is not dissimilar: the important difference is that the in the 1990s the primary revenue account of the budget was in surplus whereas it is currently in deficit.


Finally, on the back of sustained current account deficits, the rupee remained under considerable pressure in the foreign exchange market and saw a sustained devaluation. From the second half of 2011 to the second half of 2013 the rupee depreciated against the US dollar from Rs. 45 to 62.08, a fall of 38%. In the second half of 2013 rupee also came under pressure because of capital outflows triggered by fears of a tapering off of US quantitative easing monetary policy regime. But independent of that as the data suggests the rupee has been under pressure, largely due to a widening current account deficit. This depreciation as we will see below has been one of the important causes of sustained inflationary pressures.


The economy therefore got hit by a triple whammy of slowing growth, a depreciating rupee (and a rising current account deficit) and accelerating inflation.


The RBI’s view of inflation and critique


Over the last two-year period, when growth has really slowed down and inflation remained high or accelerated, its (i.e., inflation) main drivers have been food and fuel – with varying degrees of intensity over time – with a supporting role being played by non-food manufactured products. For example for April-Dec 2013 70% and 78%of increase in CPI and WPI was accounted for by these two groups. (p31 Macroeconomic and Monetary Developments – Third Quarter Review 2013-14). In addition to this for the WPI non-food manufactured products have played a supporting role.


For CPI inflation, vegetable prices have been an important driver of food inflation, particularly in 2013. In addition to fuel, vegetable and food, housing and transport and communication are other drivers of CPI inflation. Services which have also seen prices inflation have however relatively small weights in CPI.


Given levels of import integration (26% for overall imports and 14% for non-oil non-gold-silver imports) depreciation has been an important cause of inflationary pressures in fuel and non-manufactured goods. And the RBI accepts that.


“The depreciation of the rupee and the associated pick-up in input cost pressures as well as the increase in imported final products prices have more than offset the softening impact of weakening demand.” (p42, Macroeconomic and Monetary Developments Third Quarter Review 2011-12)


“High domestic fuel inflation amidst range-bound global crude oil prices reflected the impact of exchange rate pass-through and the role of administered price changes.” (p32, Macroeconomic and Monetary Developments – Third Quarter Review 2013-14)


Not only does fuel price inflation feed inflation through first round effects, because it is a necessary intermediate it fuels inflation through second round effects, for example raising the cost of transportation. As we have already noted, transportation is an important driver CPI inflation.


Instead of absorbing some part of the depreciation led increase in landed fuel costs, why did the Ministry of Finance choose to raise administered prices and further stoke short-term inflation? Whatever be the political economy of that decision, the RBI is clearly very appreciative of this policy.


“The revision in administered prices of oil could add to near term price pressures, but could help improve the macroeconomic fundamentals.” (p43, Macroeconomic and Monetary Developments Second Quarter Review 2012-13)


Cleary the Ministry of Finance and the RBI are completely in sync on this because this is what the Economic Survey 2013-14 has to say on raising administered prices:

“It is important to be cognizant of the fact that … the move from administered to market-determined prices will release suppressed inflation in the short run. Nevertheless, the consequent reduction in subsidy and  fiscal deficit will have the salutary effect of reducing inflation. [p76; emphases added]


Administered prices and closing the fiscal deficit


Finally why is the RBI so supportive of the Ministry of Finance raising administered prices of fuels? The answer to that goes back to the increase in the primary revenue deficit that has opened up alongside the increase the gross fiscal deficit post the 2008 global financial crisis.

Surely it is prudent macroeconomics to run a surplus on the primary revenue account. For the RBI increasing administered prices and thereby reducing subsidies is one way of bringing down and closing the primary revenue deficit which is why it so appreciative. But is this the only way of closing the deficit? Surely not. One can raise revenues as well. To stay with the fuel example, diesel prices have been raised quite substantially for bulk consumers. Given that this is a necessary intermediate this has first and second round price effects and therefore has high inflationary potential. Therefore instead of raising administered price of diesel (or linking it increase in global $ prices but not incorporating depreciation) the GOI could think of taxing diesel cars. They are also easy to levy and easy to collect. Or reduce taxes foregone by closing tax loopholes and withdrawing tax exemptions. But that would be going against its class interests. So it chooses to closes the primary revenue deficit by imposing the most regressive tax – inflation – on working people!


Therefore what the first budget of the BJP government has done is merely to extend the neo-liberal policies of the UPA.

Top - Home