Q&A on Economy & Trade

 Interview given to Bijoy Kumar Sing of PTI on August, 9, 2018:

Q1: What is you assessment of current macroeconomic situation in India? Some experts believe that  the macro situation is becoming more challenging in the last year of Modi  government? FDI growth hits 5-year low in 2017-18, rupee has depreciated, oil prices and inflation are rising? 

A1: Economic growth, which has been subject to many ups and downs over the past seven years, seems to be back on a recovery path. The most important indicator of this is the rate of growth of real fixed investment, an essential element of sustained, sustainable growth. On the external front some challenges such as the threat of rising interest rates and commodity prices are the negative face of a rise in developed country growth. So they are partly offsetting. The rise in oil prices due to Geopolitical factors, like Iran sanctions are however a concern.  The US-China Tariff war however provides an opportunity to increase India’s exports to the USA and to attract, labor intensive elements of the global supply chain unsettled by higher “China risk”, to India. Domestically the main risk to macro stability, is politically driven Govt consumption spending at the cost of investment and fiscal prudence. If this temptation is resisted, the country will be back on a firm 7.5% plus growth track. 

    Q2: India has emerged as the sixth largest economy replacing France? How do you see this development?

A2: in a series of papers since 2004, I had predicted the rise of China and India as economic powers (https://sites.google.com/site/drarvindvirmani/india-great-power ). India will become the fifth largest economy in 2018 and the 3rd largest, after USA &  China, by 2025 (in current US dollars). According to the index I developed for making these projections, VIPP, India will become a great power by ~ 2035. It is very important for our elites to understand both the strengths and the limitations of these developments. We must start planning our global interactions and acting like a leading power, without ignorantly imagining that we are already a Great Power (that is 20yrs away). 

    Q3: The US actions on trade have emerged as the biggest worry for global growth. What will be impact of rising trade tensions on Indian economy and what should be India's strategy?

A3: We must distinguish between US trade actions against market economies like EU, Canada, Mexico and other market economies from those against non-market China. The conventional wisdom that everyone will loose from a trade war applies to the former, but not to the latter. A single party dictatorship has dozens of ways of imposing non-tariff barriers on imports & foreign investment, that free open democracies, run by rule of law, cannot even imagine. The US-China tariff war will have some short term disruptive effects on global economy, but provides great opportunity for India to attract Labour intensive, export oriented and Indian market oriented investment from those currently located in China. The Indian Govt, private industry and PSUs must make an effort to attract them to India.

    Q4: The general elections are less than a year away and there is a possibility of populist policies being announced by both the central and state governments. Is there a possibility of slippages in the fiscal deficit?

A4: Historically every Govt pushes up what are referred to as populist expenditure in the year or so leading up to the election. The test is if they keep it modest and don’t disturb the trend in fiscal responsibility. There is therefore always a risk of fiscal slippage. At State level, this is partly linked to losses incurred by State electricity distribution. 

    Q5: Prime Minister Narendra Modi had said that demonetisation will reduce generation of black money in India. But money deposited by Indian's in Swiss banks rose by 50 per cent last year. So, how do you read the effects of demonetisation nearly two years later.

A5: The data that I have seen shows that money deposited by Indians in Swiss banks has been on and remains on a downtrend. As as demonetization, I had written the week after demonetization that it would reduce the growth rate of the economy by about 0.5-0.6% in the 6 months following the demonetization or about 1% for the year as whole (assuming the recovery takes a year). My subsequent estimates show a loss of 1.2% of GDP in the 12 months following demonetization. On the positive side I had predicted an increase in income tax compliance, which seems to be happening (as per limited data available). The effect on black money in real estate and elsewhere did take place, but seems to have been less permanent. 

    Q6: There is common perception that departures of foreign' economic advisers (Raghuram Rajan, Arvind Panagariya and Arvind Subramanian) underline the Modi administration's rejection of free trade and open market approaches to policy in favor of protecting domestic industries and farmers. Your comments.

A6: Since I retired from the post of Chief Economic Advisor at the end of 2009, my successors as CEA (Kaushik Basu, RaghuRam Rajan and Arvind Subramanian) have all returned to jobs abroad, after completing their Indian tenure. The same happened in the case of Arvind Panagriya of NIti. In my judgement this is not primarily due to any disagreement on free trade and open markets, which is indeed one of the weak points of the current Govt (I have argued for trade reform in the, Bibek Debroy edited, book, “India at 70, Modi @3.5 “ )

    Q7: Recently Commerce Minister Suresh Prabhu had said that 40 per cent of India's GDP will come from exports by 2025, and India's economy will be a USD 5 trillion economy 2025. At present, exports constitute only 18 per cent of USD 2.6 trillion GDP. Do you agree with Prabhu?

A7: An open economy is one of the drivers of growth in a connected and liberal world, which is why I have continuously argued for reform and liberalization of EXIM policy(agriculture) and of import tariffs and export duties. I continue to do so. However, given the anti- free trade sentiments sweeping the world, we have to be a little more selective and cautious in dealing with non-market, non democratic countries which find it easy to follow non-transparent policies that harm our interests. This poses a challenge for instance in concluding the RECEP agreement.

Macro Stability: Budget Priority

Introduction

Economic growth has averaged around 4.7 per cent for the past two years.  Gross fixed investment is at a standstill, barely increasing by 0.2 per cent in 2013-14 after a dismal growth of 0.8 per cent in 2012-13.   Manufacturing output is now lower than it was a year  ago, with no indications yet about.  Despite collapsing growth, inflation has averaged 7.1 per cent per annum, suggestive of stagflation.  The high inflation is driven by agricultural prices which have increase at an average 11.5 per cent despite a relatively high growth average of 3.1 per cent. The Current Account deficit shot up to 4.8 per cent of GDP but has come done to 1.8% in 2013-14, partly due to restrictions on gold imports.  This backdrop defines the immediate priorities of the incoming priorities.

Budget: Macro Sustainability

The first priority of the new government must be to restore Macro-economic balance.   The second priority is to accelerate investment and growth.  The third priority is to address the structural factors driving agricultural prices.   The budget that will have to be presented by the new government within 6 weeks of taking oath of office will provide the first opportunity to address these issues. Given the shortage of time, the budget can and must focus on those issues coming within the purview of the finance ministry.  Two major objectives would therefore be, to  put the fiscal situation on a firm improving trend and to address the problem of NPAs and Capital adequacy of Public Sector Banks 

    The BJP manifesto has promised a clear accounting of fiscal deficit.  Based on this, the should aim to reach the FRBM targets of 3% for the fiscal deficit and 0% for the revenue deficit within two years with the objective of halving the difference from 2013-14 in each year. This requires a corresponding reduction in consumption expenditures and subsides, particularly petroleum product related subsidies. It is quite clear to everyone that the damage done to corporate confidence by the retroactive changes in tax laws and harassment of corporate tax payers (what the BJP manifesto calls “Tax terrorism”), must be corrected. In addition some progress must be shown with respect to implementation of GST and simplification of income taxes.  Given that several of the holdouts were BJP States, this should not be too difficult.

    Another mistake made by the outgoing government was to force Public Sector Banks to provide credit to infrastructure projects with less than adequate long term financing.  Given the high risks associated with bad policy and regulatory environment, several of these projects would not have got off the ground. Forcing PSBs to provide credit merely postponed the day of reckoning in the form of Non-performing assets.  Re-capitalization of these Banks is therefore urgently required to revive their ability to lend to new borrowers. A policy change allowing Government holding to go below 50% will allow sale of government equity to finance re-capitalization, without worsening the (real) fiscal deficit.

Inflation: Agriculture 

 Finally the disastrous management of the agriculture sector, that has resulted in almost 10 years of high agriculture price inflation.  The minimum support pries must be restrained for the next few years, the huge buildup of stocks that has resulted in double digit price increases in wheat & cereal prices corrected.  Steps can also be taken to reform the Food Corporation of India. The likelihood of a below normal monsoon also makes it imperative to move quickly from the Ad Hoc changes in QRs and expot controls to a stable system of import tariffs and export duties.  This will help moderate price inflation and provide an incentive to farmers to investment in productivity improvement.  Greater efforts must also be made to convince States to abolish the APM or remove vegetables and fruits from its purview.

Separately and independent review must be carried out of policy and regulations in the  infrastructure and energy sectors under the purview of the Central government and the governance of Public Sector and Departmental enterprises.   Hopefully some action can be taken on these within 3 months after the budget has been passed.

A version of this article appeared in The Hindu, on 17 May 2014 under the banner, “Restore Balance in The Macro Economy,” http://www.thehindu.com/todays-paper/tp-miscellaneous/tp-others/restore-balance-in-macroeconomy/article6018606.ece

Foreign Exchange Reserves and Infrastructure

There are three different issues involved in this question which need to be addressed and answered separately before putting then together into a single package. The first issue is that of lending external reserves for domestic investment. By definition external reserves have to be kept in safe assets not affected by BOP shocks to the economy as they are held to reduce risks in such an eventuality. The Asian crises showed that external borrowing by domestic banks for the purpose of domestic lending increases systemic risk of crises. “Using” FE reserves for domestic purpose has a similar effect. If reserves are seen as ‘excessive,’ this indicates an implicit judgements that the risks are low and will remain so even with lower reserves. They are two sides of the same coin.
The accumulation of our reserves is the outcome of a BOP & foreign exchange management policy designed to meet external and domestic shocks and promote growth. If this results in “excessive” reserve accumulation the policy needs to be modified. Though the build up of reserves till September this year has roughly halved to what it was last year because of industrial recovery and higher oil and raw material policies there is scope for slowing it further. ICRIER studies have shown the positive effect of the tariff reductions since 1992, on intra-industry trade and specialization, productivity and exports. Reserve accumulation can be efficiently stopped or perhaps reversed by a sharp reduction in tariffs. A reduction in peak tariffs to 10% by 2006 and to 5% by 2008 budget and the lowering the excessively high agricultural tariffs will enhance productivity, increase exports and accelerate industrial growth.
The second issue is that of infrastructure investment and development. Experience with Telecom sector reform has shown that efficient and effective development of infrastructure requires a policy framework that promotes entry and supports competition (particularly with the government supplier). This requires isolation of natural monopoly elements through unbundling and a professional independent regulatory framework to regulate monopoly elements and ensure fair competition with the incumbent. In the case of electricity the so-called ‘Theft & Dacoity’ (T&D) losses would also have to be tackled head on if competitive pricing is to be fair and equitable to honest users. As roads are a classic ‘Public good’ policy reform is not enough and most of the burden has to be borne by the government, policy reform can be helpful high density National highways.
The third issue is that of public investment in infrastructure and its financing. In theory public investment in infrastructure, financed by money creation or by debt can be undertaken as long as the social benefit of the former (in terms of growth/productivity) is greater than the social cost in terms of inflation and/or crowding out. The former depends on the institutional structures for undertaking such expenditures, and institutional reform (of which the National Highway authority is the best example so far) is required to reduce leakage and enhance social productivity. The latter depends on unused capacity in the economy, which was very high from 1998 to 2002, but has tightened since mid-2003. External supply side (e.g. oil) inflationary pressures have also increased over the same period. Thus the conditions for both monetary and debt financing have worsened over the last 18 months. It may therefore not be wise to increase monetary expansion and thus add demand side pressure to supply based inflation nor to crowd out rising private investment with higher government borrowing. Nevertheless, if the social benefit is higher than the social cost, perhaps a financial package can be devised to get round the constraints imposed by the FRBM.
Though the package has been put together as one to “use FE reserves to finance public infrastructure,’ the following restatement/revision would appear to achieve the same objectives more efficiently: Increase government infrastructure investment in concert with, (1) A sharp reduction in tariff rates. Reserve accumulation would slow and perhaps reverse providing greater scope for non-inflationary monetization of the deficit needed to finance infrastructure. (2) A pro-competition infrastructure policy and a professional independent regulatory framework for electricity, railways, ports, airports and dams & canals, (3) Institutional reform of public infrastructure monopolies, like State electricity boards, irrigation departments public works departments (for State highways and village roads). The last two measures would enhance the benefit from increased public investment in infrastructure and thus make the costs of financing them worthwhile.

Inflation and The Way Out

Global oil prices have risen above the OPEC price band over the last 12 months. Because of general elections, the global oil price increase was not passed through into the Indian oil prices. The dismantling of the APM remained purely on paper. The Yukos crises in Russia and the blowing up of Iraqi pipelines has led to a sharp rise in oil prices to $ 45 a barrel. Only a part of global price rise was passed into the Indian market by the new Government in June. As a result of the global rise in oil prices, Indian inflation has increased by about 0.5% point, and is likely to increase further in August. Pressure on this front therefore remains.
In addition to global oil prices, raw materials and minerals prices also increased last year. After a lag of 6 to 9 months, manufactured goods prices of items which have a large component of such minerals in their inputs have tended to increase (e.g. iron ore and iron & steel). These increases were largely due to a tremendous increase in demand from China and from global recovery. Both these sources of growth have abated somewhat and inflation arising from these two sources is likely to moderate. I expect WPI inflation to decline to around 6.5 per cent by December.
The following policy reforms could be helpful in containing inflation (in India): (a) Reduce tariffs on agricultural commodities in which prices are rising sharply; (b) Reintroduce the amendment to the Coal Nationalisation Act to allow private entry in the coal sector so that there is genuine competition for imported oil; (c) Amend the Electricity Act (2003) to make the regulator independent and professional and set up a good regulatory system; (d) Launch a crusade against theft of electricity (35% to 50% of total generation); and (e) Reduce the “peak rate” of tariffs from 20% to 15% (latest by the next budget).

Fiscal Deficit & The Quality Of Government Expenditure

INTRODUCTION
With the Fiscal Responsibility Bill stalled, the pre-budget time is apposite for taking another look at this issue. Fiscal sustainability has three aspects. One is the trend in the debt GDP ratio as determined by the primary surplus/deficit and the growth rate relative to the real interest rate, second the quality of government expenditure and third the efficiency of the tax system. In this article we focus on the quality of government expenditure. One of the most important implications of the fiscal problem in India is that the government has no money to spend on essentials. The basic problem is therefore of identifying and eliminating wasteful and unproductive expenditures so that the fiscal deficit can be eliminated and more money spent on essential government functions.
INTEREST EXPENDITURE
Interest payments are a major item of expenditure, with about half of total Central government revenue spent on interest payments. They thus “crowd out” other potentially more productive items of government expenditure.
In drawing implications for the present and future it is important to look back into the past. Interest on accumulated debt is the embodiment, as it were, of past sins. That is borrowing to finance past government expenditure. In the past few decades such expenditures consisted of both government consumption (or revenue expenditure) and unproductive investment (or capital expenditure). Thus concern about interest payments is implicitly a concern about the volume and/or quality of expenditures in the past. Some of these past government consumption and unproductive government investments are rightly viewed as crowding out present government expenditures.
One implication of this line of reasoning is that to the extent that this debt was incurred in financing investment or capital it should be allocated and assigned to these investments and the concerned organizations (e.g. PSUs, PSBs, DPEs or administrative departments). A substantial part of the indirect subsidies are the cost to the government of servicing the debt assigned to each of these organizations (organized by sub-sectors & budget heads instead of by organisations). The rest is the depreciation of these assets and their quality because of lack of replacement investment. The net value of these organizations to the government (family silver or copper as it may turn out to be) is therefore the gross value of assets or equity owned by the government in each organization minus the debt incurred by government in setting them up.
The major policy implication is that, if we are concerned about government debt and interest payments, we should sell all units producing “private goods & services” and use the proceeds to repay the debt. Operationally this could be done by creating an independent dis-investment organization and assigning to it both the ownership of the equity and an equivalent amount of debt obligation and giving it the mandate to eliminate both in an efficient way over a fixed period of time. This would reduce government interest payments over time, eliminate the crowding out of current expenditures by interest payment and allow government to focus on essential expenditures.
PUBLIC GOODS
The next question that arises is what are these “essential” government expenditures that have a higher claim on government revenues? One important category consists of Public Goods & Services. Public goods are characterized by an element of non-excludability (e.g. defence, police) or very high transaction costs for pricing (e.g. local roads) so that they cannot be charged for on an individual basis. They (public goods & services) are almost by definition items that must be paid for out of tax revenues.
They include,
i) Roads [excluding major, high density highways] & Water ways [river navigability, drainage systems, flood control]
ii) Legal System [laws, courts, judges]
iii) Public security system [police, prosecutors, jails]
iv) Public Health systems [Communicable diseases, epidemic monitoring & control, Public drinking water, sewerage & sanitation systems]
v) R&D on socially beneficial areas, including tropical diseases, agriculture (e.g. appropriate crops & rotation patterns for different agro-climatic regions), pollution.
vi) Public Education [rights, responsibilities, civic & democratic virtues, public morality, productive knowledge (e.g. agricultural extension), preventive health & population restraint, pollution abatement, water conservation]
vii) Environment & Pollution, forests, parks.

Central and state governments have spread their limited resources too thinly over too many areas and items of expenditure. As a result many of these essentials have suffered from a lack of resources and attention, and the availability and quality of these public goods has deteriorated dramatically. The time taken in court cases is legendary. Those of us who believe that Bihar and Eastern UP is hundreds of miles away may be surprised to know how badly the local/ground level police systems have deteriorated in the heart of the capital of Delhi. In this era of severe fiscal problems it is in my view essential for government to go, “Back to Basics” and refocus its attention on public goods & services.
As most of these public goods will continue to be produced or supplied by government to large extent for quite some time it is essential to improve the efficiency of production in terms of cost & quality. This is considered below
EXTERNALITIES & SUBSIDIES
Degree of Externality
The second essential area of government expenditure is on subsidies for those goods and services that have large externalities. In principle all private (non-public) goods & services can be assigned to three categories: Those with high, medium and low or no externalities. Elementary education, rural water supply, adult literacy, rural secondary education and development of markets in remote, hilly & backward areas have high externalities.
Policy Implications
Two policy implications follow:
a) Phase out subsidies on goods & services with low or no externality such as Industry, power, shipping, road transport, other transport, coal & lignite.
The phase-out schedule must however give sufficient time for,
(i) Developing a clear, transparent and positive framework for private production & supply,
(ii) An independent regulatory framework for natural monopoly segments and
(iii) Consumers to adjust to higher cost-based prices (excluding X-inefficiency costs of monopoly & corruption).
b) Align the actual subsidy ordering with the ordering of degree of externality.
This is implicit in the calculation of financial gains of phasing out subsidy.
PRODUCTION EFFICIENCY
Relative Inefficiency of Public Production & Supply
Even if there is a need for government subsidy, it does not follow that the good or service must be produced and/or supplied by the government. Government should only produce and supply such a good or service if its efficiency is higher than that of the private (individual, co-operative or corporate) sector and non-profit organisations (NPOs).
There are inherent problems in government production and supply of private goods & services. The CAG & other government auditing procedures are not conducive to commercial production and supply, particularly in a highly complex economy subject to myriad risks and shocks. The principle agent problem means that public employees and their overlords have a strong incentive to first create rents & then appropriate these rents for themselves. As a result corruption has gradually become endemic and there is much evidence that government production is less efficient than private. The only profitable government entities are either ones in which resource rents (the difference between world price and the full cost of extraction) can be disguised as profits, or government created monopolies (created by banning private production or investment for decades) with no private benchmarks for comparison.
The production, supply & maintenance of most of the subsidized goods produced by the public sector can and should be progressively opened to the non-profit organisations, co-operatives and private providers. The first step would be to develop a supportive policy framework for private entry. A modern regulatory framework must also be created for social sectors where quality is difficult to judge before purchase but is critical to the future of individuals.
Solution
There are many detailed issues involved in improving the efficiency of government programs. From a broad (macro) perspective, this requires improvement in two areas through dramatic changes:
Public Accountability
The key to public accountability of government agencies supplying goods & services and government servants and political masters overseeing them is the citizens’ right to information. A “Right to Information Act” must be enacted to return this right to the public. The poor in whose name all expenditures are justified must have the right to know all the facts relating to expenditures made/justified in their name. The information needed to be made publicly available includes the names of those who have authorized or spent the money, the purpose for which the money was spent, the names of the companies or individuals who received this money and what they have produced/done for receiving this money.
Issue specific user groups must be empowered to share with Panchayti raj & other government institutions the responsibility for monitoring public activity at the village and local level. For instance, all parents of school age children in the village (or set of villages) must be part of a user group for monitoring the activities of the village primary school, its teacher and the government supplies allocated to it. Similar user groups should be set up for all local public goods and services provided by the government.
Modern Management Practices
A complete and thorough modernization of the systems and procedures for production, supply and procurement of goods & services is needed. Perhaps not more than 25% of government projects use PERT/CPM a technique of project management, a technique that was developed in World War II and taught in US engineering colleges since the sixties. According to an informal survey only a few progressive organisations like NTPC use these techniques. Modern inventory control is a subject I recall discussing with the Navy chief over a decade ago, only to read in the newspaper recently that the armed forces still do not have modern inventory management systems.
INCOME TRANSFERS
Many government expenditure programs are hypothetically directed at the transfer of income to the poor, while several subsidies are justified by such reasons even if the externality is low. An additional consideration enters the picture in this case: The (transaction) cost of direct vs. indirect transfers. Indirect transfers have some self–selecting features but higher transaction costs. We must start experimenting with the use of new smart card technology for providing income transfers to the poor, in place of the plethora of poverty alleviation programs with enormous administrative cost and notorious leakages.

Demand Recession And Industrial Policy

About six months ago it appeared that Industry was facing a sectoral (Keynsian) growth recession. Data available at the time indicated that industrial production, as measured by the IIP, had grown by 9.5% to 10% during the first half of 1996-97, and was still growing at 10% in October. At the same time there were indications that the large corporate sector was undergoing a slowdown in growth during 1996-97. These included poor demand for bank credit, declining sanctions by Financial Institutions, a fall in non-oil imports, and, company first half year sales results [qualitative results as reported in the media]. I had suggested (in a paper) that this paradox was due to the fact that the large corporate sector was facing a “Keynsian” cyclical recession. Among the factors affecting this segment of industry were the passing of the hump in supply of, demand for, and investment in, higher quality consumer durable goods, including automobiles. Other factors included the lagged affect of the tight money policy in 1995-96, the falling prices and low demand in equity markets, and political uncertainty during and after the elections.
Since then there has been a sharp fall in growth of industrial production (IIP): from 9.7% in the first seven months to 3.2% in the last five months of 1996-97. The slow growth of power production during 1996-97, which seemed to have had relatively little effect on the corporate sector, perhaps because of increased captive generation of power, has clearly affected overall industrial growth. Other factors which have affected overall growth of industry are the fall in agricultural productions & income during 1995-96 and a sharp fall in export growth from November (due both to slowing world imports and real exchange rate appreciation) . All three factors would affect small & medium industry as much as, if not more than, the large corporate sector. Thus what started as a sectoral growth recession appears to have been pushed into a more general growth slowdown during the last five months of 1996-97, because of these additional factors.
The policy actions taken during the first half of 1997 were expected to reverse the growth slowdown. These included decontrol and further reforms relating to the banks and financial system, easing of monetary growth, and the reduction in personal and corporate income tax rates. The recovery of industrial production in April 1997 can be attributed partly to these and other policy measures relating to the infrastructure and industrial sectors. But much more can be done in the areas of de-control and reform of public utilities, both at the central and state levels, to ensure faster recovery.
The sharp recovery of agricultural production in 1996-97 will not only reverse but add to the demand for industrial goods, while easing supply of import controlled goods (artificial non-tradables). Interest rates have declined and credit availability has increased over 1996-97, while stock prices have been buoyant since the beginning of 1997. Actual supply of credit is expected to catch up gradually, among other things through increased credit for investment in the Power and Telecom sectors. One would similarly expect a recovery in the primary market during the rest of the year. International organisations had forecast a recovery of world import growth in 1997, though the extent of this recovery will now depend on the impact of recent developments in ASEAN. Policy can support recovery of Indian exports by moderating the pressure on the rupee to appreciate; This can be done by de-controlling imports, by freeing other current account transactions such as purchase of hedge instruments, and by liberalising capital outflows.

Macroeconomic Transition: Supply To Demand Cycles

The Puzzle
A prominent feature of the Indian economy in 1996-97 was the contradiction between good performance, as measured by official statistics, and reports of “recession” in newspapers based on corporate sources. Besides large corporations, sub-sectors dependent on them such as capital market intermediaries and advertising apparently shared this feeling. In 1996, CSO had forecast economic growth to be 6.8% in 1996-97, only marginally lower than in 1995-96.[1] CSO also forecast a 10.6% growth of manufacturing, which was somewhat lower than last year, and a 3.7% growth of Agriculture (& allied sectors) which would constitute a sharp improvement. Facts available till January (when the economic survey is normally finalised) supported this forecast: Industrial production (IIP), grew by 9.8% in the first half of 1996-97, compared to an average growth of 7.5% in the eighties and 8.5% during the seventh plan. Manufacturing grew by 12.4% during April-September 1996 compared to 12.5% growth in the first half of 1995-96(IIPM). There were however some indicators signalling a significant slowing down of corporate growth during 1996-97. Among these were, (a) poor demand for credit by large corporations, (b) declining sanctions by financial institutions, (c) a fall in non-oil imports, and, (d) company first half-year sales results [qualitative results as reported in the media]. This “Duality/Dualism” in the economy between industry in general and the large corporate sector have been a puzzle during the second half of 1996-97.
Cyclical Fluctuation
Earlier economic downturns in the Indian economy have been associated primarily with cycles in rainfall and agricultural production. Over the last decade or so the connection between these agricultural cycles and Industrial production has considerable weakened. Low or negative growth of GDP from agriculture in 1995-96 had little impact on industrial production during that year. Thus such supply side [Classical/Neo-classical] cycles have not been an important feature of the economy for some time. The conventional wisdom about developing countries such as India also holds that such economies are not subject to Keynesian demand driven cycles of the kind common in developed countries. Such “Keynesian” cycles are driven by the interaction of demand fluctuations with downward price rigidity and cost-push factors (in contrast to neo-classical sectors where price flexibility ensures demand-supply equilibrium). It is my hypothesis that in the transition from a closed to an open economy such a “Keynesian” sub-sector is emerging, consisting primarily of large capital intensive corporations. A cyclical “Keynesian” slowdown or growth recession in this large corporate sector provides an explanation of the puzzle outlined above.
The last few years have seen the transition of the economy to a higher growth path following from the various policy reforms undertaken since 1991-92. These reforms also have their effect on the macro-economic interrelations in the economy. The removal of controls has to a significant extent reduced the protection provided to large corporate industry, putting competitive pressure and providing increased opportunities. This has forced corporations to rapidly achieve economies of scale by building capacity in anticipation of future growth, and to upgrade products and plants to meet potential competition. The “animal spirits” unleashed by the early spate of reforms, perhaps also resulted in over-optimistic forecasts of demand growth for new and/or upgraded products. A hump is demand for durable goods and slow adjustment in real interest rates accentuated the mismatch between capacity addition and demand growth. The deterioration in non-tradable infrastructure has raised its effective cost. This in turn has put upward pressure on costs of production. The supply problem arising from import controls on agricultural goods, which artificially creates non-tradable goods, has added to this cost pressure. Though the relative price of manufactures has fallen sharply during 1996-97, the fall was probably less in the large capital intensive sectors. This combination of falling demand and rising (infrastructure) input costs resulted in a Keynesian excess supply situation for these sub-sectors, which can plausibly be labelled a “growth recession”
Corporate Demand
Among the identifiable sources of fall in demand for the corporate sector the most important one related to the pent-up demand for higher quality consumer durable goods [e.g. cars, white goods]. The de-licensing of investment in durable goods and the de-control of imports of parts for the same, led to a boom in investment and production of consumer durable goods, culminating in the phenomenal 37% growth in 1995-96. The decline in growth of consumer durable goods to 9.8% in the first half of 1996-97(compared to 31.9% in the first half of 1995-96) and further to 6.5% in the first nine months of 1996-97 suggests that the pent-up demand for higher quality durable goods have been met. Further growth will depend on increased cost competitiveness or introduction of new (innovative/adapted) products. The former requires fuller exploitation of the comparative advantage that India has in production of (skilled & unskilled) labour intensive parts.
Other sources of decline in demand during 1996-97 included a sharp fall in the growth of World imports, a real appreciation of the Rupee and a decline in new orders for capital goods. The relatively tight money policy in 1995-6 led to an expectation that high real interest rates would persist into the future (wrongly in my view, as high interest rates were due primarily to high investment demand). This affected new demand for both consumer durable goods and capital goods in 1996. The decline in agricultural production during 1995-6 may also have contributed to the demand slow-down for the corporate sector. As a result the growth rate for April-December 1996 was 10.1% for manufacturing and 8.3% for Industry.
Import Liberalisation and Substitution
Another aspect of macroeconomic transition was the import hump commonly resulting from the opening of international trade and investment. Accelerated modernisation and development of the relatively backward consumer durable sector, likely required higher initial imports of capital goods, parts and components. This led to a higher than normal growth in imports during the last few years. This hump in imports seems therefore to have passed, accentuating the import slowdown; non-oil imports (revised DGCI&S) consequently grew by only a 2% during the first 11 months of 1996-97.
Capital Markets
The credit and capital markets are also undergoing major changes during this transition period. Growth in bank credit to the non-food sector and Sanctions by development finance institutions (DFIs) declined dramatically during 1996-97. This implies a fall in demand from large, triple, corporations. Disbursements by DFIs, however, grew at a respectable pace; implying continuing high levels of investment coupled with a sharp fall in new starts. Household saving invested in shares and debentures declined from 1.3% of GDP in 1994-5, to 0.6% of GDP in 1995-96. This decline probably continued in 1996-97, and made it difficult to raise equity funds. Besides the direct negative effect on corporate investment, this also raises debt-equity ratios, making it difficult for banks to lend for investment. These changes, along with the rise in foreign direct investment and GDR issues, suggest that the fortunes of the large corporate sector are getting linked to continuing globalisation and acceleration in foreign direct investment and inflow of equity & debt capital.
Infrastructure Cost Push
The slowing of industrial growth in the first half of 1996-97 was clearly attributable to a dramatic slowdown in the growth of the electricity and mining sectors. The 10% decline in crude oil production was a major contributing factor in the latter. During the first nine months of 1996-97 electricity production (as measured by the index) has grown by only 3.7% that is 2/3 rd of the 8.9% growth in the first nine months of 1995-96. Given the high correlation of 0.67 between manufacturing and electricity (over the past 25 years), it was somewhat surprising that manufacturing production was apparently unaffected by the slow growth in electricity production. To an extent, highly electricity intensive industries are the first to face power rationing and this would dampen the effect of less public supply on manufacturing output. It is likely that own account electricity generation has substituted for the lack of generation by electricity boards. The high growth of diesel imports coupled with normal refinery throughput is a pointer. This substitution, however, provides no relief from the rising effective cost of electricity, and the cost-push that it generates.
Investment & Capital Goods
Another aspect of the macro puzzle was acceleration in the rate of growth of capital good's production to 18.2% in the first half of 1996-97 from 14% in the first half of 1995-96. This on top of the new peak in total and Private gross fixed capital formation to 24.1% and 16.3% of GDP respectively, in 1995-96. In complete contrast, import of capital goods declined by 4% in the first half of 1996-97. This showed the strength of the domestic capital good's industry, which was initially subject to the fastest tariff reduction so as to ensure quick recovery of private fixed investment. The move to more uniform tariffs on manufactured goods has contributed to the removal of anomalies and to the growth of capital goods production.
There has, however, been a slowing down in the growth of capital goods production in the third quarter of 1996-97. As a result, the rate of growth has declined to 11.8% in the first nine month of 1996-97, significantly lower than the 17.9% growth in the corresponding period of 1995-96(Import growth till February is nil.). This happened despite an easing of monetary growth during 1996-97 and a decline in market interest (call money and T-bill rates), partly because interest rates for private borrowers lagged these developments. The growth pattern for capital goods supports the hypothesis that previously started investment plans were being completed during 1996-97, while new starts were declining. Nevertheless, fixed capital formation seems to have remained strong in 1996-97.
Macro Policy, Reforms and Growth
The above analysis leads directly to a number of Policy conclusions-- both “Dos and Don’ts”. Given the very circumscribed and limited sub-sector of the economy subject to the growth slowdown, a conventional aggregate growth stimulus would have been (and is) the worst policy response. Thus for instance a higher fiscal deficit, providing such a stimulus would have aggravated the infrastructure problem and the cost push elements and raised the inflation rate considerably. In contrast the effect on aggregate output would be limited to the effect on the large corporate sector. Thus any inflation output trade-off from such a policy would be very limited, and possibly illusory.
The appropriate policy response had (and has) several elements. The infrastructure constraint was addressed by a number of policy reforms and initiatives designed to ease the entry of the private sector in the provision of these services. The second important problem was the lag in response of interest rates to the easing monetary policy and reduced demand for credit. A number of procedural and other actions were taken culminating with more fundamental reforms in the financial sector as per the Credit policy of April 1997. The 1997-8 budget, one of the most outstanding since 1992-93, cleared the air of pessimistic expectations, which hung over the corporate sector in the third quarter of the year. The reductions in personal and corporate income tax rates will not only provide an environment for efficient growth but also will also partly address the demand growth slowdown in the corporate sector.
Sustained growth of 7% to 9% will however require quicker and bolder action with respect to the electricity sector. The most urgent is the setting up of central/regional/state regulatory authorities, which are strong and independent and have the power to discipline the SEBs and to regulate both tariffs and conditions of supply. The second critical need is for reforming the State electricity boards themselves. The faster and deeper the policy reforms in the infrastructure sector, the quicker will be our approach to a high growth (employment, output), low inflation, internationally competitive economy. Flexible and speedy policy response and a pragmatic approach to reforms are also needed to generate new leading sectors and maintain high growth.
[1] Many commentators have confused forecasts given before the year has ended with estimates produced after the year has ended. These are quite different animals, as even the best forecasters in the world frequently revise their forecasts.

Inflation and Import Liberalisation

The inflation rate has been falling fairly steadily since the beginning of 1995, and is expected to continue on this path. This has happened despite the increase in aggregate demand arising from the sharp increase in industrial production and the step up in GDP growth. The demand factors which have restrained inflation during 1995 are a lower fiscal deficit( as % of GDP) and tighter monetary policy. On the supply side the continuing growth in agricultural output has played a positive role, and this is expected to continue given the normal monsoon forecast. The freed imports of several commodities such as edible oils, sugar, cotton and rubber also has a restraining effect, though rising world prices have nullified this potential benefit in some cases. As world demand growth is slowing, the impact of these measures will be enhanced. The build-up of food stocks, though it suppresses inflationary expectations, also reduces current supply. It has therefore to be carefully managed over the rest of 1995-96 to ensure a restraining effect on inflation.
Further declines in inflation in the medium term, will depend critically on the fiscal deficit, trade policy and policy for, and investment in, non-tradeable goods. Since the seventies, poor public saving performance and low expenditure productivity, to which the fiscal deficit is related, have acted as a drag on the economy. A sustained reduction in the fiscal deficit of the Centre and States, through a reduction in unproductive revenue and capital expenditures, is essential for simultaneously attaining both higher growth and lower inflation.
Trade policy affects those goods, which are available in international markets and can be readily transported. Most goods fall in this category. The transfer of all these goods to OGL by the end of the eighth plan as envisaged in the plan document, would make it possible to reduce inflation. As the last few years surge in world GDP growth has now plateaued and may even decline in the next few years, this will reduce the pressure on critical agricultural and intermediate goods prices.
There are a few agricultural goods such as pulses and gram in which the world market is very limited or non-existent. Such goods are effectively "non-tradeable", and productivity enhancing investments in R&D and extension, will be needed if supply is to keep pace with demand.
The most critical area of non-tradeable for the future is infrastructure services. The speed at which policies, rules and procedures are changed to attract private investment will determine how far inflation can be reduced. Transparent procedures which generate public support can speed up private investment to fill supply gaps. Power distribution and rail transport, the two sectors in which private entry is still restricted, are most likely to hinder a further reduction in inflation. Privatisation of urban power distribution and entry of private providers for freight and passenger services, coupled with establishment of Independent regulatory agencies are possible solutions.
The average rate of inflation since 1970-71 has been a little over 9% per annum. It was, however, significantly lower than this in the 1950s and 1960s. The average inflation rate depends on the degree of openness of the economy and the rate of increase in productivity.
The eighties were characterised by an average inflation rate lower than, and a growth rate higher than, in the seventies. The policy reforms initiated in 1980 played an important role in this development. Once excess capacity is used up, faster growth can however, generate inflationary pressures. These pressures are most likely to emerge from the non-tradeable infrastructure sectors. The experience of East Asia shows that the correlate on can be reduced by faster policy reforms, better governance, reduced fiscal deficits and increased private including (direct) foreign investment.