A difficult year has gone by and an uncertain year lies ahead. Needless to say, business in an uncertain macroeconomic environment is more complex to manage, than business in an adverse year. This is true from a policy making perspective, as also from an operational viewpoint. As the looming uncertainty is not the result of a single factor there can be no single answer, no elegant solution that will deliver a quick turnaround.
Haseeb A. Drabu
The dangers of managing the economy or business in uncertain environs lie in erring on the side of underestimating the extent and intensity of the downside. There is an obvious upside and it can be tempting to drive the business on the basis of what is “likely to happen” rather than “what could happen”. However, taking the latter route minimizes the risk, even as it leaves scope for some pleasant surprises.
This means that in the year ahead, conservatism should be the best course of action, be it policymaking or business. It is time for industry and financial institutions to strengthen the internal systems and controls and exploit productivity and efficiency gains for enhancing the bottom line.
However, even as there are uncertainties about growth and markets, the economic future of India looks bright. In other words, the long-term prospects are based on structural advantages while the short-run problems have arisen out of situational infirmities. The big policy challenge is to ensure that the situational infirmities do not impair the structural advantages on which the India story has been built.
In order to understand the impact of the current bout of inflation or to predict the efficacy of policy measures in reining it in, two points need to be made about its character: first, is that roots of the current bout of inflation are not monetary. Second, it is not the case of plain vanilla inflation. It is more a part of the “impossible trinity” and as such is intertwined more with capital inflows, exchange rate, and interest rates. This makes the situation extremely complex and policy formulation difficult. It can be managed but only if the fisc is in order, which is far from the case at present.
Structurally speaking, the type of inflation that is pervading the economy is in the genre of “profit inflation” rather than “income inflation”. It is fuelled basically by excess demand for a variety of goods, notably primary commodities, including food articles. To that extent it is so, supply management measures such as imports of certain essential commodities being allowed will augment domestic supplies thereby making short-term adjustments of supply to demand at a certain level of price.
However, it is more important to recognize that this is the first time since liberalization in 1991 that the economy is witnessing demand-led profit inflation. This is because the main focus of liberalization was on the fiscal side, which sought to keep the level of autonomous demand deflated.
In terms of policy action for controlling inflation of this kind, it will help to recognize that one of the distinguishing features of profit-inflation is that it is self-limiting. The logic of this is that the forced savings that such an episode of inflation generates, eliminates the excess demand.
It is only till such time that this happens, that monetary policy has to play a role. In other words, there are limits on monetary measures effectiveness in the medium and long term. This is not to suggest that the measures introduced by the Reserve Bank of India will have no impact. They will moderate the enabling environment with which inflation can become a spiral in the short term. But it can’t be relied upon to prevent the situational negatives from impairing the structural positives. To prevent the situational infirmities from damaging the strong structural factors of the economy, monetary measures need to be supplemented by fiscal policy measures, more specifically public expenditure policy. The structure and financing of public expenditure has to change even if its level is maintained at the present levels.
Contrary to exploring the possibility of cutting rates being contemplated by the ministry of finance, there is a case for increasing the tax-GDP ratio in a period of profit inflation. This is because during this period, the income of the rich increase, while squeezing the consumption of the poor thereby having an adverse impact on the income inequalities.
To the extent that the share of profits in total income has increased because of profit inflation, it stands to reason that the tax/GDP should be hiked through taxation on profits. In a sense, fiscal policy must do to companies, what RBI is doing to banks!
This will change the financing pattern of public expenditure. Along with this, the composition of autonomous public expenditure and investment should be changed in favour of flexible-price fixed-output sectors in the economy. This is crucial because the response to excess demand will then not be on the price front but on the output front. It is this that lies at the heart of the working out of a policy package that doesn’t negate the financial sector reform, which have been under way since 1991. Indeed, these measures would not only be consistent with, but would also add a structural dimension to the ongoing economic reform.
Haseeb A. Drabu is chairman of Jammu and Kashmir Bank Ltd and economic adviser to the J&K government. He writes on the macroeconomy. Respond to this column at firstname.lastname@example.org