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Business News/ Home-page / Budget must open economy’s many blockages
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Budget must open economy’s many blockages

Budget must open economy's many blockages

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By Andy Mukherjee, Bloomberg

Finance Minister P Chidambaram should present investors with a credible plan for opening the blocked arteries in the economy.

This year’s government budget, which Chidambaram will unveil in parliament tomorrow, must address the challenges of an overheating economy.

That doesn’t mean Chidambaram has to roll up his sleeves and set out to bring down aggregate demand in the economy. That’s central bank Governor Y.V. Reddy’s unpleasant task.

What Chidambaram has to do -- and this can’t be done by monetary policy -- is to boost the capacity of the economy to produce more goods and services so that the current 9 % pace of economic growth becomes sustainable.

How is this to be achieved? There are no shortcuts.

Suppose Chidambaram decides to cut the corporate-tax rate to, say, 30% from 34%.

The temptation for such a move does exist.

Corporate profits are playing a huge role in financing the good times in India. In the four years through fiscal 2006, the growth rate of the economy accelerated from less than 4% to 9%. The bulk of the resources for this expansion came from a doubling of non-state corporate savings -- retained profits -- to 8% of gross domestic product.

Giving a further boost to corporate profitability will, thus, be the easiest way for Chidambaram to keep the economy growing at a scorching pace.

The question is: Will cutting the corporate-tax rate be prudent at this juncture?

Prudent or Risky?

After all, a potential short-term effect of such a reduction may be to increase demand.

And that may be risky when inflation at 6.6 % is already much higher than 5.5 %, the upper end of the central bank’s tolerance zone.

Among other supply-side measures, Chidambaram will probably cut the peak rate of import tariffs to 10 % from 12.5 %. A recent survey of business executives in India shows that this move is widely anticipated.

Whatever tax sops the finance minister announces in the budget, he has to keep in mind that Governor Reddy will inevitably have to tighten monetary policy and nudge demand down to more-manageable levels.

The telltale signs of overheating in the Indian economy -- high inflation and asset prices and a persistent current-account deficit -- underscore the need for a hawkish monetary policy.

Otherwise, India may well be headed where China found itself in the early 1990s: 17 % economic growth with 27 % inflation.

Overheating Economy

A number of constraints limit the economy’s capacity to create more goods and services.

Among the biggest culprits are inadequate public investments in roads, ports, power and other key enabling industries.

For Chidambaram to be assured that today’s economic growth can be sustained without accelerating inflation, he has to double infrastructure spending to 8 % of GDP, estimates Morgan Stanley economist Chetan Ahya in Mumbai.

From land and labour to capital, every aspect of production in India suffers from serious supply-side shortages.

Property prices are escalating because the market is inefficient. Supply of land with clear titles isn’t growing quickly enough; reallocation of farmland to industrial projects is being thwarted by allegations of unfair compensation and land grab; outdated urban-planning rules are preventing efficient utilization of space.

Bottlenecks

The local banking system, most of it controlled by the state, is too small and its cost of intermediation of household savings is too high. As a consequence, the small- and mid-sized firms aren’t able to grow for want of decently priced credit.

The labour market is tight because an underdeveloped primary education system is denying children in state-funded schools the minimum skills that a modern economy asks of its workers. Only people who can afford private schooling for their children are able to corner the new employment opportunities in the fast-growing services industries.

Meanwhile, those areas that could absorb large chunks of surplus labour from agriculture -- such as electronics manufacturing -- are yet to prosper. The much-awaited tax sweeteners to manufacturers of semiconductors, disk drives and liquid-crystal displays were cleared by the government last week after much bureaucratic hand-wringing.

Inelastic Supply

Ever since the Indian economy began opening to the world in the early 1990s, the budget has become the government’s most-important tool to articulate its economic policies.

Chidambaram may not like it, but his priority for this year has already been defined by the central bank.

“As long as supply responses are less than elastic, they could show up as excess demand, causing inflationary pressures and raising inflation expectations," Reserve Bank of India Deputy Governor Rakesh Mohan said in a speech on 13 February “Our assessment is that while expansion of capacity is under way, the realization, particularly in sectors like infrastructure, could be constrained over the next two years," Mohan said.

Two years is too long a time to let the economy perform above potential. A prudent budget this year will be one that shuns populist giveaways and shows how the blockages in supply of goods and services will be removed quickly.

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Published: 27 Feb 2007, 11:27 AM IST
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