India - Interview C.Rangarajan

The Prime Minister’s Economic Advisory Council recently revised the economic outlook for the current fiscal year, projecting growth to slow down to 7.7%. EAC’s outgoing chairman, C Rangarajan , who recently took up a parliamentary role as member of Rajya Sabha, discusses the latest report of the council and the global economic prospects.

We remember you saying in an interview to us two years ago that policymakers globally had forgotten the effect of money supply on inflation. The current realities in global markets seem to have vindicated that foreboding. The liquidity overhang in the global markets has accentuated inflationary pressures all around, including in emerging markets like India that are less tolerant to inflation. When will the liquidity pressures moderate?

One of the factors driving prices is aggregate monetary demand. In India, we’ve seen large increases in net capital inflows in the last three years, particularly so in 2007-08. This kind of surge in capital inflows is bound to have an impact on money supply to the extent inbound capital isn’t sterilised. It is evident that money supply increase within the country has largely been influenced by external factors.

The EAC has now forecast that net capital inflows in 2008-09 would be $70 billion, two-thirds of the last year’s, but still a large figure for that matter. This is because developing countries would doubtless remain an attractive destination for global investors, flush with funds, seeking a gainful investment options. A 7.7% GDP growth (predicted by EAC) would continue to make India an attractive destination for global finance capital. So, despite the likely expansion of the current account deficit (CAD) to over $40 billion this fiscal, the net accretion to RBI’s foreign exchange reserves would still be around $30 billion. Capital inflows this year would be smaller than last year, yet very substantial. Most of the inflows will be during the second half of this financial year.

These relatively smaller capital inflows, coupled with CRR hike (which will affect the money multiplier) would moderate money supply growth in ‘08-09. Our estimate is that the broad money supply growth will come down to 18% or even less this year. (It was 21% in ‘07-08). Of course, the ideal target is to keep this rate at about 17%, given the trends in growth rate.

How will this moderation of capital inflows impact growth?

There will be a slowing down of growth, but that is going to result from a variety of factors, not just a moderation of capital flows. The slowdown would be due to several external factors – the sharp increase in global commodity prices (oil, food and base metals) is impacting us. Of course, there’s been some cooling in world commodity prices in the recent weeks and one hopes this would continue. It cannot be denied that the global economic slowdown itself will have an impact on India.

The International Monetary Fund had estimated the global economic growth last year at around 4%. What could be the likely scenario this year?

I guess it could be 2.5% or so. As for developed economies, the growth figure could just be little over 1%. As I said, this slowdown will certainly impact us. Some softening of the growth rate (India’s) due to global factors is inevitable. But there is also another side to this story. In a sense, funds are available globally (there’s somewhat of a glut in global savings), but the investment climate in developed economies is not conducive to productive investment. So, the global savings are seeking an outlet. Developing countries like India displaying a strong urge to grow will continue to attract these funds.

There’s a view that the full possible effect of the global slowdown is yet to dawn on India.

The main channel through which global forces can impact India is exports. In terms of demand for Indian’s exports to be precise. And the other is capital inflows, which I discussed earlier. So far, we haven’t been severely affected by the global slowdown on the export front. Though export of services may have been affected to an extent, so far there hasn’t been a severe impact on export of IT and IT-enabled services.

Of course, it remains to be seen how things will shape up during the second half of the fiscal. But it must be reckoned that developed economies are under pressure to cut costs and this could lead to increased outsourcing to countries like India. Our estimate at present is that non-oil merchandise exports would grow 22.5% this fiscal.

But with interest rates climbing, do you think investment demand in the Indian economy will be intact? It’s feared there could be a slowing of infrastructure investment

We have forecast that investment rate this year will more or less be the same as last year’s, somewhere around 37.5%. Recent IIP data (April-June ‘08-09) have shown a reasonably good growth in consumption goods, indicating that investment growth will be sustained. But there could be a decline in savings rate—both public savings and private corporate savings could see a decline. The CAD of 3.2% to GDP that we have projected reflects an overall savings rate close to 34.5%, significantly lower than investment rate and so bucking the trend of recent years.

Oil prices are seemingly softening. How exactly will this impact the Indian economy?

The impact of the moderation of oil prices on the economy will be seen on several fronts. It could ease the pressure on balance of payments. It could also dampen inflationary expectations. We have estimated trade deficit to be 10.4% of GDP this year, up from 7.7% last year. That estimate presumed that overall import bill would grow some 30%, with an 80% increase in oil imports. Now, if the oil price falls to around $100, the trade deficit could be significantly lower than we have projected. And of course, a decline in oil prices would also see off-budget liabilities (oil and fertiliser subsidies) coming down.

However, since the global oil price increases are only partially reflected in domestic prices of petroleum products (due to the inadequate pass-through), a fall in global oil prices might not immediately have a substantial impact on domestic prices.

In the revised economic outlook, the EAC has said that coordinated policy action, coupled with a dip in world commodity prices, and monetary actions by other central bankers would bring inflation rate down to 8-9% by March ‘09. Does that mean that despite the predicted slowing of money supply growth, the RBI would need to further hike policy rates in the course of the year?

Oil price decline would dampen inflationary expectations and capital inflows are likely to moderate. If that is the case, there may not be a need for further tightening of monetary policy. But for the RBI to feel comfortable, there should be a perceptible softening of the rate of inflation.

As for monetary authority in the US, even as inflationary tendencies had began to appear, it was influenced more by the consideration to ensure financial stability. So, instead of raising the interest rates, it lowered the rates. So, the Fed did not take strong action to combat inflation even though it was expected to do so, as a central bank. Strong monetary authorities do raise interest rates as part of their efforts to combat inflation.

Speaking of interest rates, which, according to you, is the true yardstick for determining the cost of funds? Real interest rate for the borrowers– nominal minus inflation- is still negative, but the rate that makes a psychological impact is the nominal rate.

Where should the real rate of interest settle down is the critical question. You are right that people generally tend to look at nominal interest rates, although they should have considered the real rate instead. In a purely closed economy, the real rate of interest could be equal to the rate of growth of the economy, but not so in the case of open economies. Maybe, the real yield on a 10-year government bond is a good indicator.

Industrial production data (IIP) of the first quarter of this year showed a growth of just 5.2%, against 10.3% in the corresponding period of the previous year. Despite this, you have estimated the industry to grow at a somewhat robust 7.5% for the whole year, which means growth in excess of that in the last three quarters. Isn’t that a bit a too optimistic?

Our projection of industrial growth might look high, but we have reckoned factors that could lead to an increase in industrial output in the next three quarters. First, electricity generation, an IIP component, grew just 2% in the first quarter (as against 8% in the corresponding period in the previous year).

This is totally unacceptable for a fast-growing economy. Quite reasonably, one should expect substantial improvement in this sector in the next three quarters. Ideally, growth rate in the power sector should exceed that of the economy as a whole. At least, electricity generation should increase pari passu with industrial production. In the current circumstances, a growth rate of 7-8% is imperative in the power sector. Secondly, the IIP figure looked dismal in Q1 partly because of the base effect, as industry grew very strongly in the initial 4-5 months of last fiscal.

In the second half of last fiscal, industrial production started slipping and this would be reflected in the growth rates of IIP figures in the next three quarters. The EAC in its report has also pointed out the need for revising the Index of Industrial Production to get at the real picture. In the final analysis, even if industrial growth could be somewhat lower than what we have estimated, a higher than projected farm sector growth (EAC’s present estimate is 2%) would ensure that, on balance, the projected 7.7% GDP growth would hold true.

The drop in GDP growth this fiscal, you said, has to be seen as modest in view of the global developments. What about the coming years? Do you see the prospect of higher growth rates?

I think the Indian economy will revert to 8-9% growth rate in 2009-10. This because external factors that have dampened growth in the current year would diminish by then.

You have highlighted the undesirability of off-budget liabilities.

Indeed, we will have to proactively decide on how to deal with the practice of issuing oil and fertiliser bonds. In fact, the government should not resort to such bonds to finance subsidies. We will have to phase this (practice) out and bring complete transparency into the subsidy financing. The (growing) incidence of off-budget liabilities and some under-budgeted commitments like farm loan waiver, NREGA and the Sixth Pay Commission would mean that fiscal deficit, broadly defined, would be much higher than budgeted figure of 2.5% at the end of the fiscal.

On the revenue front, apart from the buoyant tax revenues, there is now the possibility of raising additional (non-tax) revenue through disinvestments and telecom licensing. This could help in moderating the fiscal deficit.