New Delhi: In June last year,Chakravarthi Rangarajan, chairman of the Prime Minister’s economic advisory council, or EAC, warned the Centre against continuing inflationary pressures in the economy. Though the former Reserve Bank of India governor expects the inflation rate to “stop short” of double digits, he says in this interview that it is “uncomfortably high” and should remain a major cause for concern through the year. Edited excerpts:
Is inflation driven by global factors or are there domestic pressures as well?
Inflation anxieties: EAC chairman Chakravarthi Rangarajan says that although the impulse for inflation came from domestic factors, global factors such as rising commodity prices compounded the problem
The inflation rate started rising in India initially because of domestic factors. We are, in fact, somewhat insulated from outside factors. The impulse from inflation came essentially from domestic factors but, was compounded later by rising global commodity prices, in particular oil prices. Domestically, some shortages existed and some were about to develop. The money supply has also been increasing at a rapid pace, in excess of 20% for three years. More recently, the external factors started impacting domestic prices. The rise in oil prices in India is still modest. Once the impact of the oil price hike comes through on the retail prices, we will see inflation crossing 9.5%.
Will it touch double digits?
It may stop short of a double-digit figure. My own estimate is that it would take up to September-end for the inflation rate to come down to 8%. If the monsoons are good and expectations are in the right direction, you could see a further fall to 7-7.5% by December.
That would be an average inflation of 7.5% for the fiscal year?
It could be. For almost six months of the current year, the average inflation could be above 8%. So the average for the year could be around 7-7.5%, even though there could be a substantial decline in inflation by March 2009.
Despite a very timely warning by the EAC last year, the government seems to have lost the inflation battle. Why?
Several international factors were not clearly seen at that time. The iron ore prices, their impact on steel prices, the order of the increase in oil prices —all these were quite unexpected. Even three to four months ago, we never expected oil prices to go above $90 a barrel. In some sense, events overtook us.
Do you see more hikes in rates?
Monetary measures are always gradual and respond to short-term changes. One doesn’t want to raise rates beyond a certain level. But with 8% inflation rate, the real rate of return on many deposits is close to zero. So I would not rule out the use of monetary instruments. As for non-monetary measures, we have used up most of our options. If prices tend to rise further, despite favourable factors, then monetary action is called for. The trend in prices is what we need to observe. Like I said, whatever we do, prices may not fall below 7% till December.
And that is still an unacceptable number?
And that is still a very high number. So the Reserve Bank of India (RBI) has to watch the situation.
Will the farm loan waiver programme and the Pay Commission recommendations fan inflation?
I don’t think the loan waiver package will be a major factor influencing inflation though the consumption of some industrial goods could increase. The salary hike, on the other hand, would be a big factor, though it will depend on if the government decides to phase out payment of the arrears.
Both inflation and interest rates had gone up very rapidly when you were the RBI governor. Is the current situation more complicated?
True, we had raised rates, but we had also brought down the inflation rate almost by half, and that sharp fall created concerns in the minds of people. But the external factors are playing a bigger role this time. In all these inflationary episodes, the major contributing factor has always been domestic, except in 1973-74. In recent times, money supply growth and fall in agricultural production and shortages have been more important. We have also become a more open economy and the external factors are not favourable now.
But industrial production is steadily going down.
Controlling prices as well as stimulating production are top priorities. It is like treating a patient. But when the fever is very high, you have to take medicines to bring it down, which may have some side-effects. Inflation is highly uncomfortable, and strong monetary actions such as raising interest rates or the cash reserve ratio, have to be taken.
In the light of higher inflation, would you revise your growth forecast?
In January, when we came out with our annual review, we forecast a growth rate of 8.5% for 2008-09. I think now, taking all the factors into account, the rate could be 8%. We cannot expect agriculture to grow at last year’s 4.5%. I expect it would be around 2.5-3%, partly because of the base effect. Manufacturing growth rate will be 8%. There could be some slowdown in service, so I would put the GDP growth at 8% but not below that.
Is the balance of payments coming under pressure? Do you see the current account deficit widening?
The trade deficit would widen in the current year primarily due to the oil import bill. Merchandise imports would be as high as $317 billion and exports could be $200 billion, and so trade deficit could be as high as $120 billion, almost 9% of the gross domestic product, or GDP. Invisibles may not be strong but will still be significant. Overall, then, the current account deficit (CAD) would be a little over 2%. Capital flows will abate during this year but could still touch $75 billion, leading to an accretion of reserves of about $45 billion. In that sense, balance of payments would deteriorate from the last fiscal but there would still be a small surplus on the capital account.
So long as the CAD is at a reasonable level, and normal capital flows are adequate to cover it, we should not worry. I would certainly worry if the deficit was 3% of the GDP. We cannot compare ourselves with export-driven economies, though we haven’t done badly at all on exports in the last fiscal. Something like 20-22% growth could still be possible on exports.
There could be some weakening of the rupee but I wouldn’t worry about that too much. In fact, I would expect the rupee to stay at the same level as it is now for the next several months, practically the rest of the year.
What are your major concerns this year?
Certainly the high inflation rate is a very major concern and it will remain so for the rest of the year. On the real side, hopefully, it will still be possible for us to grow at 8% this year, which should be regarded as good. The signs are that monsoons will be good, and so agriculture will continue to grow and that will ease the situation as far as prices are concerned towards the end of the year. This means, on the real side, I am not as worried as much as I am about inflation. However, I would ask for much more focus on infrastructure and development of power. Electricity generation has been very poor.
The fiscal situation has changed since the Budget was presented. And the off-budget liabilities would be growing too if the oil and fertilizer companies are compensated….
All the new things should push the fiscal deficit closer to the fiscal responsibility and budget management (FRBM) target (of 3.3%) than what was projected in the Budget, of course without the off-budget liabilities.
Is this a true reflection of the government’s true liabilities?
No, it is not the best way to present it. For many years, we have followed this practice if cash outgo is not involved. But for a true assessment, these liabilities should be added. I think more than anything, the time has come to focus on reducing the subsidies. I had argued that on fertilizer subsidy, we should move to an entirely different scheme of supplying all farmer households a fixed quantity at an official subsidized price and leave the balance to be determined by the market.
But, fertilizer subsidy reforms are not politically popular.
We really have to educate people on the magnitude of the subsidies, I mean Rs90,000 crore is a huge amount. We can fix the quantity at 125kg a year, we can also raise it depending on the target group. But we have to start moving in that direction.
Do you see your suggestions in the financial inclusion report getting diluted?
We wanted the banks to universalize the business correspondent scheme (regarding appointment of agents by banks in the hinterland to collect deposits from the public and deliver credit to those who wish to borrow). On that, the RBI has made it easier for banks to recruit such correspondents. But the responsibility lies with the commercial banks to take it forward. We had also suggested that non-banking finance companies and microfinance companies be accepted as business correspondents, at least in accepting deposits. On that, RBI is yet to take any action.
What is your view of the Raghuram Rajan report on financial sector reforms?
It has many interesting suggestions and small steps that could be easily adopted. But some of its suggestions on monetary policy, and its objectives are independent of financial sector policy reforms and there could be difference of opinion on that. I personally think price stability is the most important objective of monetary policy. Whether that dominant objective is translated into a particular inflation target or not is a different question.