An economy in a hard spot

An economy in a hard spot

Index of Industrial Production (IIP) data for November 2010 shows that manufacturing is tanking. The sub-index for manufacturing shows a growth of only 2.3% (year-on-year) compared with the same period in 2009. Overall, IIP grew by a snail-like 2.7% (y-o-y) from the same period the year before.

While IIP is high-frequency data and there have been considerable swings due to the base effect and seasonal factors in the past year, there is a clear downward pressure on the index. That, however, is only one part of an increasingly worrisome economic scenario. When seen together with high inflation and double-digit food inflation, the danger signals are clear.

The situation would not have come to such a pass had the Union government not run a loose fiscal policy. It is true that it will meet its fiscal deficit target this year. But that is due to a high nominal gross domestic product (GDP) growth of 19.8% in the first half of the year compared with the estimate of 12.5% made in February. This has enabled the government to rake in taxes. Plus the 3G spectrum sales and other one-off items have also enabled it to meet its targets. But the continuous rise in inflation shows that these targets are “rigged" and the feeling of control is illusory.

If the Union government had its way, it would concurrently run a loose monetary and fiscal policy and also believe it could control inflation. The fact is it cannot even in theory and certainly not in practice. The economic data shows that clearly.

There way forward now is for the Reserve Bank of India (RBI) to tighten monetary policy by raising policy rates. To say that RBI is in a dilemma because it has to choose between maintaining conditions for growth and check price rises is false. There is no such dilemma: The key task of the central bank is to quell inflation and for that more tightening is now necessary. If rising interest rates shave off a percentage point or so of growth, then the blame would clearly lie with the government and its reckless fiscal profligacy.

The way ahead, in the coming fiscal, would be for the government to curb spending. This will require it to take a hard look at its spending priorities. Some amount of social sector spending has to be crunched if the gains from it are to be retained and not lost to inflation. This would reduce its need to borrow money and as a result reduce some pressure on interest rates marching north. This would also have a stabilizing effect on prices.

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