COMMENTARY
RBI on Medium-Term Challenges
R K Pattnaik
The Reserve Bank of India Annual Report 2010-11 reflects a strong academic input in the discussion of the short- and medium-term challenges, the foremost among them being inflation management. Policy options are listed, but they will have meaning only if the government and the central bank can together initiate action.
R K Pattnaik (rkpattnaik@simsr.somaiya.edu) teaches at the KJ Somaiya Institute of Management Studies and Research, Mumbai.
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Growth Outlook
The growth outlook as projected by RBI for 2011-12 is expected to decelerate from the trend annual growth of above 8.5% during 2010-11 to about 8%. Some of the factors as emphasised by RBI as adversely affecting growth are persistent inflation pressures, rising input cost, increase in cost of capital due to monetary tightening and slow project execution. Subsequently, in the mid-quarter monetary policy review released on 16 September 2011, the RBI observed that with the weakening growth movement in advanced economies and with a slowing down of domestic demand on account of the tight monetary policy stance, the “risks to the growth projection for 2011-12 made in the July review (8%) are on the downside”. This statement has some element of self-contradiction as, on the one hand the RBI recognises the adverse factors likely to affect the growth momentum but, on the other, rules out the downside risk.
In the above context, it is worthwhile to examine the sectoral performance and take a view on whether 8% growth will be maintained in 2011-12. Based on the trend so far, there is no downside risk to agriculture and services growth but the outlook for the industrial sector remains uncertain. The latest data on the Index of Industrial Production and Purchasing Managers Index signal a slowdown in the manufacturing
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sector. Thus, the combined effect suggests some downside risk to the 8% growth for GDP in 2011-12 that has been projected by the RBI.
In this context it is critical to comment on the Twelfth Plan (2012-2017) approach paper’s target of 9% to 9.5% GDP growth.
This order of growth requires enhancement of the domestic savings rate, foreign savings (proxy variable being the current account deficit), and/or a decline in incremental capital output ratio (ICOR). While the RBI’s annual report has broadly touched upon this development, it has not explicitly stated a very important aspect, i e, the need for a complete elimination of negative saving (proxy variable the revenue deficit) in government administration.
Inflation
The RBI report and subsequently the midquarter review observed that inflation remains high, generalised and much above the comfort zone. The rise in non-food manufactured product inflation suggests continuing demand pressures. Furthermore, the annual report emphasises a hardening of global commodity prices and transmission of such price shocks to domestic inflation (Box 2.3 of the Report). In view of this, the central bank has been successively increasing the policy rate and ensuring monetary tightening to contain inflation and anchor inflationary expectations.
In the above context, the RBI has raised two important questions, viz, (a) why has inflation persisted and was this predictable?
(b) Was monetary tightening adequate? The RBI mentions that inflation persistence was on account of both demand pull and cost push factors (paras 1.6 and 1.7). The report has further added that inflation became difficult to predict in 2010-11 due to unforeseen price pressures in the form of unseasonal rains during the post-monsoon period of 2011 and sharper than expected rise in global commodity prices.
The answer to the second question is i ndirect. The report speaks about the constraints faced by monetary policy as inflation is supply-driven. In this context, it is recognised that monetary tightening helps to maintain some check on the spillover e ffects and expectations of high inflation.
It is pertinent to note that in theory and also in practice there is a limitation to
COMMENTARY
fighting inflation through monetary policy instruments if supply constraints predominate and are sticky. It is, therefore, important that the government along with the RBI fight inflation through a comprehensive policy package. This would include prudent fiscal management with effective and efficient cash management, an agricultural policy that emphasises producti vity and augmenting protein commodity production. These are areas where government policy intervention is urgently warranted. This is more so as supply side inflation spills over to demand inflation. At the present juncture RBI action on its own will be counterproductive.
As observed from the annual report, the persistence of inflation above the comfort level of RBI resulted in a choice of sacrificing some growth to contain inflation. The RBI believed rightly that “Inflation hurts growth and must be contained”. In this context it has revisited the concept of “Threshold Inflation” (Box 2.4) and has found that such inflation for India is in the range of 4%-6%. The central bank also recognises that the desirable level of inflation may be even lower than any estimated threshold level in view of the distributional consequences of inflation. One can hardly differ with the RBI on this stance.
Fiscal Consolidation
Contextually, the RBI report has rightly emphasised two aspects, viz (a) “further fiscal consolidation is necessary for macro stability”, and (b) “quality of fiscal adjustment has long-term growth implication”.
According to the RBI, though rolling targets set for fiscal deficit seem achievable, at the current juncture achieving a revenue target appears to be a challenge. In Box 2.13 it has analysed the rule-based framework with a cross-country survey. In this analysis the RBI has inter alia emphasised the importance and relevance of capital outlay. Furthermore, to highlight the quality of fiscal adjustment in the context of long-term growth implications the RBI has observed that the fiscal multiplier is generally found to be higher in the case of capital expenditure. The RBI analysis on these aspects is highly relevant. However, as a matter of observation it must be mentioned that it is a misconception that all capital expenditure is growth inducive. The fiscal multiplier approach focuses more on the magnitude of expenditure but certainly not on allocative efficiency and return on capital. The latter is more important as it has implications for the non-tax revenues of the government budget.
In view of the foregoing, it is appropriate that in the revised fiscal architecture the government should aim at the elimination of revenue deficit per se at the earliest and not focus on the misguided notion of the “effective revenue deficit” which excludes grants to state governments from the revenue deficit. It is expected that the RBI at least in its theoretical discussion (which would not necessarily reflect views of the institution) should have stated that the latter is not a correct way of defining the revenue deficit. Grants to states are a constitutional and discretionary outcome. It is non-tax revenue for the states. Excluding this item from the compilation of a revenue deficit under fiscal rules is a clear case of creative accounting.
Sustainable CAD
The annual report while reviewing the external sector has observed that the current account gap has improved and the improvement has come about by cyclical upswings in global trade and turnaround in invisibles. The report also recognises the diversification of trade in terms of composition as well as direction of trade. While commenting on the current account deficit (CAD) it is observed that the deficit is within the “threshold level” of 2.7%-3% of GDP. A sustainable CAD at 2.7% and 3% of GDP is also important in an open economy context. This implies that the upper limit of foreign savings is 3% of GDP.
The concept of a “threshold level” of sustainable CAD according to the empirical estimates of RBI (Box 2.17) depends critically upon capital flows ranging around 4%-4.5% of GDP. The report further mentions that 3/5th of these flows are to be non-debt creating flows.
Two issues are critical here, viz (a) interest sensitivity of capital flows, and (b) the hierarchy of flows. With regard to the former, an RBI study that is cited concludes that foreign direct investment (FDI) and foreign institutional investor (FII) flows are not sensitive to interest rate differentials. At the aggregate level, cumulative capital flows appear to increase by 0.05 percentage points
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in response to a 1 percentage point widening of the interest rate differential. As regards the latter, it may be noted that at the present juncture, one of the most important items under non-debt capital flows is FDI. The data for 2010-11 revealed that the net FDI inflows were of the tune of $11.6 billion due to significant moderation in gross inflows coupled with higher gross outflows.
Twin Deficits
The RBI report has recognised the risks of a twin deficit, i e, the fiscal and current account deficits. In the event of a weakening of the global economy and the likelihood of a spillover to the domestic economy during 2011-12, the twin deficits will require close monitoring. In theory, the spillover effect is well recognised. In the Indian case, the spillovers in the past were not significant. However, with the increased degree of openness, this could be a critical issue. While the financing of the CAD is analytically addressed by the RBI, a discussion of the financing of the fiscal deficit is conspicuously absent. For example, the recourse to a longer period of Ways and Means Advances (WMA) even on a higher scale coupled with overdrafts during the first half of the current fiscal and surpluses thereafter speaks about weak cash management. Therefore, a close monitoring of the financing of the fiscal deficit, particularly the cash surplus and WMA trend is critical and has a policy priority as it adversely affects monetary policy and debt management.
Policy Options
The content of the RBI Annual Report 2010-11 in terms of analysing the emerging i ssues and policy recommendations has the flavour of a strong academic input and high pragmatism. The RBI and government jointly should list out the recommended policy actions with a time frame for initiating action.
The immediate challenge is to bring down inflation to acceptable levels. While the RBI has earlier stated in different fora that its comfort level on inflation is 3% in the long term, it has recently also spoken about inflation of around 4%-4.5%. In the report under discussion the threshold inflation is 4%-6%. One is now confused about what the acceptable levels are and
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what low and stable inflation for India should be. Notwithstanding the magnitude and level of inflation, the policy priority has to now shift from monetary to complementary policies as emphasised by the RBI. These include improved supply response for food, storage capacity, water management, cold storage, and public policy intervention to link rural wage programmes to productivity. The government should consider the RBI suggestions in this regard
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seriously. Apart from increasing the share of agriculture and industry coupled with enhancement of savings, policy intervention should be on lowering ICOR. The present ICOR of four is at the bottom of international benchmarking as the global range is between two and five. The efficiency of capital and return on capital through technological upgradation is a policy priority. Closely related to this is infrastructure financing. This requires policy intervention
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-to encourage resource flows to the infrastructure sector on a commercial basis.
On fiscal consolidation, the policy priority should be on eliminating the revenue deficit at the earliest through a revised Fiscal Responsibility and Budget Management framework. The concept of “effective revenue deficit” should be dropped as it is irrelevant and encourages creative accounting. The provisional capital outlay should linked to a return on capital.
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