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India at a turning point

India at a turning point
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First Published: Tue, Jan 11 2011. 08 24 PM IST
Updated: Tue, Jan 11 2011. 08 24 PM IST
The first decade of the new century saw economic growth trending up and inflation trending down. Are we now on the cusp of a reversal? Will the next ten years see India struggle with higher inflation and a flattening growth curve?
Take inflation. The sudden resurgence in food inflation this winter has taken the government by surprise. The official explanation when food prices started accelerating in 2009 was that this was the result of a poor monsoon and that a good crop in 2010 would soon bring food inflation under control. The view then was that inflation was up because of a supply shock that would dissipate once farm output recovered on the back of a good monsoon.
Nothing of the sort happened. The persistence of high food prices has led senior officials to now say that the government does not have adequate tools to control inflation. Home minister P. Chidambaram even said: “We do not understand all the factors that contribute to price rise”. Chief economic adviser Kaushik Basu said in an interview to The Financial Express that faster economic growth pushes up the inflation rate by two percentage points, as domestic prices catch up with international prices.
There is undoubtedly some merit in these explanations. The spike in food prices came at the same time as a similar jump in global prices. There is empirical evidence that the correlation between domestic and international food prices has increased in recent years, thanks partly to the fact that many agricultural commodities are traded on commodity exchanges and their prices have become “financialized”. They move in tandem just as the prices of industrial commodities such as iron ore and zinc do.
Also, the secular rise in food prices —especially fruit, vegetables, eggs, milk and meat—is because of rising incomes. The standard short-term policies the government has to manage demand are fiscal and monetary policies. Neither has much bite when it comes to quelling food inflation. Export bans are a tax on farmers. The real battle is to increase supplies through higher investment in agriculture and the building of nationwide cold chains by modern retailing firms.
Basu quite correctly points out that domestic prices in an emerging economy eventually catch up with those in rich economies. But this usually happens in services that are not traded across international borders. Prices of traded goods tend to settle at the same level across the globe when there is trade. The gap between prices of services such as hair cuts narrows as erstwhile poor countries catch up with rich countries—the so-called Balassa-Samuelson effect. However, the spurt in inflation right now is being led by food rather than services.
Now let us turn to economic growth. The Economic Survey presented by the finance ministry in February 2010 discussed how double-digit growth is within reach. The underlying building blocks are clearly in place, especially a young population as well as high savings and investment rates. Yet, the hubristic belief shared by the Indian elite that double-digit growth is just a matter of time is way too simplistic. Many investment banks are already saying that economic growth in FY12 will be lower than growth in FY11. Rating agency Crisil said in a recent research note that it expects the Indian economy to grow at an average 8.4% between FY12 and FY16. In short, growth will be impressive but well short of the double digits.
This column has often pointed out that the Indian economy is hit by high inflation every time growth moves beyond 8.5% for a few successive quarters. This speed breaker could act as a spoiler of our national ambitions. India needs to raise the level of economic growth it can sustain without sparking off an inflationary fire. My own view is that the lack of interest in economic reforms since 2004 has led to this state of affairs. India is currently using the dividends arising from the economic reforms pursued by the Narasimha Rao, United Front and Atal Bihari Vajpayee governments. As my fellow Mint columnist V. Anantha Nageswaran noted in his piece this week: “Many countries have stood on the threshold of higher economic growth and widespread prosperity, only to fritter them away through complacency.” Brazil and many Latin American nations are obvious examples of high-growth economies that lost their way.
What happened in China at the beginning of its third decade after the 1979 reforms is instructive. There were clear signs that the Chinese economy was slowing down at the turn of the century. Economic growth between 1999 and 2002 averaged 8.3%. Then it all changed. Chinese economic growth in the next seven years averaged 11% while consumer prices grew by a modest 3%.
Global pressures combined with the lack of meaningful economic reforms are sending inflation and growth in the wrong directions. There is a short-term trade off between the two, which is why the Reserve Bank of India will have to aggressively increase interest rates even if it means sacrificing some growth. But economic reforms can help India overcome this bump on the road.
The curious combination of policy procrastination and hubris is a risk that can no longer be ignored.
Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at cafeeconomics@livemint.com
To read Niranjan Rajadhyaksha’s previous columns, go to www.livemint.com/cafeeconomics
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First Published: Tue, Jan 11 2011. 08 24 PM IST