If prime minister Manmohan Singh’s party is to return to power, it will have to navigate carefully through rising prices while engineering a soft landing for the economy
Nothing focuses the minds of politicians in an election year like angry voters.
As it enters the final year of its term, prime minister Manmohan Singh’s United Progressive Alliance government is waking up to the fact that fast economic growth may not be enough to win re-election. Public anger at rising food prices means Singh’s government will find it hard to win another mandate, despite having overseen an economy that has surged at 8.8% annually for the past four years.
By the end of March, weekly rises in wholesale prices had climbed to 7.4% – a 31⁄2-year high – even as the economy looks likely to have slowed to about 8.7% in the year to March 2008, from 9.6% in the previous year. Scepticism over India’s ability to sustain its breakneck growth has also grown.
Despite the mounting pressure, India’s finance minister Palaniappan Chidambaram shrugs off such concerns. Sitting in his office in the imposing North Block in Delhi, he tells Emerging Markets: “As long as growth is maintained above 8%, we should not worry about it. We should take it in our stride.”
While he admits that “if there is a slowdown in the world, India cannot be insulated from it,” Chidambaram points out that current projections put growth for the year 2007–08 at between 8.5% and 8.7%. “That is still a very impressive performance,” he says.
Of course, a mild economic slowdown – brought on in part by a tight monetary policy since October 2004 and a rising rupee – may not be such a bad thing if it slackens pressure on blistering prices. But with the next general election expected before May 2009, the nightmare scenario for the government is that economic growth drops off a cliff just as prices surge.
Yet navigating through the headwinds of rising prices while engineering a soft landing for the economy will not be easy.
For a start, widespread and enduring political problems are tying the government’s hand on policy options: the fallout of a growing and largely neglected agrarian crisis has already cost Singh’s administration dearly – the high rates of suicide among impoverished farmers (150,000 deaths between 1997 and 2005 according to the, some say conservative, National Crime Records Bureau) are no longer restricted to poverty- and drought-stricken areas; farmers in comparatively productive regions such as the Punjab are now taking their own lives amid soaring personal debts.
In a bid to win back farmers’ support, the government has taken unprecedented action: in his February budget, Chidambaram unveiled a $15 billion debt write-off for poor farmers – the largest ever such move. The decision clears the way for new bank loans to farmers by June, the start of the next sowing season. But it is also widely seen as a last-ditch effort to shore up local food supply in what looks likely to be an increasingly fraught year.
Chidambaram remains confident that the solution to rising prices lies in a process of reform whose results will not appear overnight. “As long as we import commodities, and the global prices are high, we are importing inflation. In the medium to long term, the answer is to become self-sufficient, at least in food grains and food items,” he insists. “We have taken a number of steps. But the results will not be visible in a year, only over a period of time.”
Food for thought
But policy-making is constrained in another key respect. The IMF, in its latest World Economic Outlook (WEO) report, points out that unlike China, whose fiscal position is relatively robust, the scope for a fiscal stimulus in India to counter a possible economic slowdown is slim.
For a start, Indian consumers pay much less than they should for fuel and imported food. India imports three-quarters of the crude oil it consumes, but the government has not passed on to consumers the full burden of the global spike in prices. Moreover, the IMF points out that India’s growing demand for food imports is itself putting pressure on global prices.
In March, as countries began setting barricades on their stockpiles of food, India too placed restrictions on export of rice, edible oil, steel and cement, cut import duties on edible oil and building up domestic stocks of food for distribution.
Chidambaram says that the measures were unavoidable. We will try to manage inflation “by aggressive procurement [of food], more effective distribution through the public distribution system and judicious imports of items in short supply,” he says.
By April, it appeared the government may consider direct price controls on some commodities like steel and cement. “The rise in international commodity prices in the past year is incredible, and even a small imbalance in supply and demand creates inflationary expectations which are difficult to manage, but we will manage them, Arvind Virmani, the government’s chief economic adviser, tells Emerging Markets.
The challenge is critical because, as prime minister Manmohan Singh warned recently, a growing backlash against economic reform could undermine economic growth. As prices soar, pressures for restrictive trade practices will mount, and the “constituency for economic reforms, so necessary to stimulate economic growth, will also diminish,” Singh said.
Tight policy
As far back as October 2004, India’s central bank began worrying that an overheating economy could lead to inflation and started making money dearer. Since then the repo rate (at which RBI lends to banks) is up by 175 basis points, the reverse repo rate (at which banks park their cash with RBI) by 150 basis points and the bank cash reserve ratio (the proportion of deposits a bank must place with RBI) by 325 basis points.
In an interview with Emerging Markets in Mumbai in early April, Reserve Bank of India (RBI) governor YV Reddy said, “We have been flagging inflationary pressures over the last few quarters. By and large we have not loosened demand too much because, in our view, demand management has to be consistent with supply.”
Though the global situation today is “complex” and “uncertain”, India may be better placed in managing growth and inflationary pressures than some other countries because the economy has been “less imbalanced”, Reddy pointed out.
Analysts are divided on how effective monetary policy can be when inflation is imported. Robert Prior-Wandesford, an economist at HSBC, says that India, like many other countries, is “hostage to the rise in international commodity prices, and the scope for national monetary policy is small.
“If the RBI raises interest rates, it may have little impact on inflation, and the economy could slow down more sharply,” he says.
India may instead be better off allowing the rupee to rise against the dollar (since most commodities are priced in dollars) to ease the pressure of imported inflation, he points out.
Suman Bery, head of the National Council for Applied Economic Research, a Delhi-based think-tank, argues that monetary policy may yet prove critical. “Imported inflation represents a loss of income to the economy, and there are more and less inflationary ways in which this terms of trade loss is distributed through the economy. Tightening monetary policy is at least one instrument available to accommodate this loss,” he says.
Rajiv Malik, an economist at JP Morgan Chase, argued in a recent report that the RBI should tighten monetary policy because local demand pressures “emanating from an expansionary fiscal policy remain meaningful”.
“Doing nothing is not an option,” he said.
In a clear indication that the central bank intends to keep cash on a tight leash to bring inflation down to under 5.5% by next March, the RBI raised the cash ratio for banks by 75 basis points to 8.25% in April. The bank expects economic growth to slow down a bit this year to between 8-8.5% from 8.7% in the previous year.
But in any event, the RBI faces a tough situation: if it raises interest rates – thus widening the already considerable interest rate differential with US rates – and allows the rupee to rise against the dollar, it risks encouraging foreign capital inflows, another source of inflationary pressure in the recent past [see box]; it also risks hurting exports and growth.
The challenge ahead
India’s policy-makers are watching carefully the extent of the slowdown in developed countries for clues to how soon pressure on global commodity prices might ease. The IMF forecasts a “mild” US recession this year and a recovery from 2009. Meanwhile, India’s economy is forecast to slow down to 7.9% this year and next, according to the WEO report released in April.
But worries persist that US dollar weakness will keep commodity prices high, as investors treat the latter as a safe haven; sooner or later the Fed will have to hike interest rates to reabsorb the liquidity it pumped in earlier – and to keep a lid on inflation.
Just how the global credit crunch will play out in commodity prices and capital inflows to India is unclear. But what’s readily apparent is that for India’s government, what’s in store is a trial by fire – even before it faces India’s increasingly restive voters in the next election.