The inflation targeting regime shouldn’t constrain Indian manufacturing

Manufacturers find themselves in a situation where they are producing products whose prices are not rising (and are often falling), even as their labour costs continue to rise, since they need to maintain real wages.
Manufacturers find themselves in a situation where they are producing products whose prices are not rising (and are often falling), even as their labour costs continue to rise, since they need to maintain real wages.

Summary

  • Is credit too expensive in India? The Reserve Bank’s rate-setting panel goes by retail prices to keep inflation in check, but policymakers must analyse the price dynamics of the entire basket of items that make up national income.

The recently concluded Monetary Policy Review reiterated the concern of high CPI inflation and recommended keeping the repo rate unchanged. This review, however, marked an interesting increase in dissent within the policy committee: Two of the three non-Reserve Bank of India (RBI) members voted for a reduction in rates.

This panel has six members, of which three are from within RBI. To understand the concern of these independent members, it is important to remember that insofar as the formal literature in macroeconomics is concerned, prices mentioned in the discussion of price stability refer to something called the ‘aggregate price level’ of the economy.

This price level is linked to the transactional matrix of the economy: i.e., the prices underlying all transactions. In simple terms, the consumer price index (CPI) captures the prices of goods and services that make up final consumption. It ignores the prices underlying the vast structure of intermediate transactions inherent to a complex economy.

Also read: Is MPC doing enough on inflation? Consumers are divided

The limited coverage of CPI would not have made a difference if all prices were highly correlated. However, this has usually not been the case in recent years. The accompanying graph, for example, shows the complex diversity of inflation in different subgroups of the wholesale price index (WPI).

Notice that in most months, the highest inflation is in the food index. The decision to target CPI was a consequence of a recommendation of an RBI committee headed by a then deputy governor which felt that the CPI would better capture the lived experience of consumers.

It was influenced in part by the general experience of most countries through the 1990s and the early 2000s, when consumer prices were highly correlated with producer prices. In an earlier article, I referred to an NBER study which had brought out the growing divergence between CPI and PPI (producer price index) globally since the mid-to-late 2000s.

Unsurprisingly, this divergence correlates with China’s entry to the global trading system as a full-fledged member of the World Trade Organization and a huge shift in manufacturing production to China.

If we were to restrict attention only to those items in the WPI basket which make up final consumption, then the resultant index would track the CPI quite well. Thus, the difference between CPI and WPI is not because of a difference in retail and wholesale market prices, but the difference between intermediate and final consumption.

The low WPI inflation rate in recent years therefore hides behind it low—and often negative—inflation in investment goods and key intermediate inputs originating from the manufacturing sector.

This low inflation in products produced by a large part of the factory sector is a major factor behind the crisis faced by Indian manufacturing.

Manufacturers find themselves in a situation where they are producing products whose prices are not rising (and are often falling), even as their labour costs continue to rise, since they need to maintain real wages.

Also read: A decade of ‘Make in India’: Why our factory sector is looking up

Concern over sluggish manufacturing has been flagged in the Economic Survey and by numerous statements from senior members of the Union Cabinet. Their words clearly highlight India’s need to improve manufacturing growth so as to create better jobs.

The government is also seeking to support manufacturing through schemes like the production-linked incentive programme and by re-calibrating tax policies and import duties. The high cost of funds and restricted availability of credit to this sector, however, remains a major challenge.

RBI has sought to partially address this through a small reduction in the cash reserve ratio (CRR). While this will increase liquidity, it does not address the cost of capital. In fact, the repo rate right now is almost the same as the yield on long- term government bonds.

In effect, this high cost of borrowing results in a form of adverse selection, where only risky projects that can generate high returns seek institutional credit.

One of the contributing factors to the last cycle of high non-performing assets (NPAs) that banks experienced was that the high-interest-rate regime of the late 2000s constrained bank lending to risky projects, which eventually failed. A sustainable banking system requires a relatively low cost of credit, which would help maintain an adequate balance between risk and return.

Aggravating the problem is the fact that large corporations increasingly rely less on institutional credit and either directly borrow from the markets or rely on their suppliers to carry a larger burden of their financing. Thus, the dependence on expensive bank financing is primarily being faced by the micro, small and medium enterprise (MSME) sector.

While the government is seeking to address this by increasing emphasis on targeted lending (as mentioned in the recent budget), it does not change the underlying cost of such credit.

A focus on reduced collateral requirements for MSME lending, without a corresponding reduction in the interest cost, increases the banking sector’s vulnerability to risky lending and a higher NPA burden as a future consequence.

Also read: Growing jobs, tepid output: Contrasting story of manufacturing industry in 5 charts

The essential point is that inflation targeting must analyse the price dynamics of the entire basket of commodities making up national income, rather than keeping a narrow focus on a subgroup of commodities going into final consumption.

An analogy can be drawn from medicine, where good doctors treat a patient and not a test report.

The author is a former chief statistician of India

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