What a difference a month makes. A little over a month ago, the meeting of the empowered group of ministers to increase the administered prices of diesel, LPG and kerosene was repeatedly postponed as policymakers vacillated over even modest increases to domestic fuel prices.
This seemed symptomatic of the policy inertia that has characterized the last two years. Big-ticket policy reforms are conspicuous by their absence. The goods and services tax (GST) is stuck in a political quagmire, the direct taxes code (DTC) has been watered down to the point of ceasing to be a significant reform, pension and insurance reforms still languish, land acquisition issues continue to fester and impede large projects, and regulatory uncertainty has increased sharply over the last year.
Add to this rising macroeconomic uncertainty. Headline inflation has remained above 8% for 18 consecutive months—significantly above policymakers’ expectations and comfort zone. But even as core inflation rose and inflationary expectations got increasingly entrenched, the Reserve Bank of India (RBI) persisted with its sluggish policy response, raising rates only in 25 basis points (bps) increments through all of 2010 and the first part of 2011.
In sum, both the cyclical policy response to slow aggregate demand and quell inflationary pressures and the structural policy response to facilitate a medium-term supply response by jump-starting policy reforms seemed in disarray.
• A second wind?
But something appears to have changed in recent weeks. Policy sluggishness seems to be increasingly replaced by desire to clear the mounting backlog across a variety of issues.
To start with, authorities finally acted boldly by increasing the retail price of petroleum products (more than the market had expected). Additionally, in a reformist move, authorities explicitly fiscalized the government’s share of remaining losses so as to reduce the continual uncertainty that plagued burden sharing between different stakeholders. What was encouraging about the move was the fact that authorities decided to take it on the chin and explicitly fiscalize these subsidies, rather than try and conceal their fiscal impact.
Then, last week, the economy came one step closer to a potentially significant reform: allowing FDI into multi-brand retail. If approved, this has the potential to deliver significant benefits to the economy. For starters, it could potentially result in significant foreign investment into back-end infrastructure, which, is likely to help rationalize the supply chain from farm-to-fork. The current supply chain is marked with inefficiency resulting in significant delays, waste, and capture by middleman, which has likely contributed to keeping food inflation high as well as impeded the transmission of price signals from consumers to producers, thereby limiting the needed supply response.
On the same day last week, a cabinet committee gave unconditional approval to the $7 billion Reliance-British Petroleum FDI deal, expected to provide a much-needed fillip to FDI inflows that contracted sharply last year, even as neighbouring China experienced record inflows!
Additionally, the government is likely to table a land acquisition Bill in Parliament. While the provisions of the Bill are likely to be contentious and come under much debate, the fact that a law will likely be in place sooner rather than later is expected to reduce the uncertainty premium that is increasingly being attached to land acquisition and serving to deter private investment.
Finally, first signs that the political impasse over GST could eventually be resolved were visible when a member of the opposition Bharatiya Janata Party was elected to head the empowered committee on GST. While there is still no dramatic breakthrough on this issue and the GST will miss its April 2012 deadline, the appointment of a key opposition member to head this panel could eventually facilitate a political compromise. It is important to underscore that the GST is a potentially game-changing reform expected to result in significant revenue buoyancy and large efficiency gains through the creation of a common market.
It is, of course, possible that this could be another false dawn. Each of these initiatives could potentially stall. But the fact that a multi-pronged policy offensive is finally under way?suggests that policymakers understand the cyclical and structural implications of inaction and may have found their second wind.
• Shock and awe from RBI
This mindset change is also typified by the change of approach by RBI. Finally recognizing that its calibrated approach was not working, RBI caught the bull by the horns and raised policy rates by 50 bps in two of the last three meetings. Tuesday’s rate increase needs to be particularly commended. Even as inflation hovers around 10%, is likely to accelerate further in the months to come, and expectations of inflation a year from now hover at 13%, many in the market had expected RBI to signal a pause and were discussing rate cuts in the future. To them, this was much-needed shock and awe.
Instead, RBI needs to be commended for recognizing that if inflation is allowed to fester at these levels, inflationary expectations risk getting completely unhinged, and the demand destruction that is required to rein in inflation gets progressively larger. It is heartening to find that policymakers finally recognize that we will have to sacrifice short-term growth to protect medium term growth. And until inflationary pressures abate, a broad-based pick-up in the?investment?cycle appears unlikely.
For once, both cyclical response to quell inflation and the structural response to increase the growth potential seem to be working in tandem. Let’s hope policymakers are able to time the tide and ride the wave.
Sajjid Chinoy is the India economist at JPMorgan.
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