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Managing the Recovery

with Rupa Chanda, Professor

India is at a very crucial stage of economic recovery. With high growth rates, increasing industrial output, India seems to be out of the recession blues and well on the path of recovery. RBI recently reviewed its target growth to 7.5% this year from 6% earlier. All this, though, has come at a price. Consumer prices are at never before levels. Inflation is at decade high. Annual food inflation based on the wholesale price index (WPI) stood at 17.28 percent for the week ended Jan 2. Though the WPI has eased marginally, food prices are 22% higher than last year which is among the highest in the world.The traditional policy dilemma of maintaining growth or reining in inflation has acquired a particularly sharp edge this time. RBI has raised CRR and is expected to raise it further. Goldman Sachs calculates that government spending contributed 40 per cent to 50 per cent of India's total GDP growth in the year to September, and economists worry that hiking rates before private investment gains traction could undermine the recovery. Is this then the right time to withdraw liquidity is anyone’s guess.

    Response to the Crisis

    tejas@iimb: India’s knee-jerk responses to the impending financial crisis were conventional measures to infuse liquidity in the system. In the January review RBI gave first indications of a withdrawal?

    RC: In fact, RBI had given signals of tightening even in the last quarter. It had raised SLR (Statutory Lending Rate) and had increased provisional requirements for funding to real estate. It was changing its stance form managing the crisis to trying to address possible fallouts of increased liquidity. That had set the tone and people were expecting some tightening.

    tejas@iimb: Do you think it is the right time to start withdrawing these easing measures?

    RC: I would say this is a good time to start withdrawing these measures. Some argue that inflation has more to do with commodity prices which have been a problem for a long time. They contest that the need is for agrarian reforms and monetary policies cannot have much of an impact. But I disagree. Monetary policies are aimed at lowering inflationary expectations. Long term expectation has heightened interest rates on long term holdings. It is a pre-emptive measure to prevent inflation from going too high. Rather than doing it in big jerks, it is always better to take gradual steps.

    tejas@iimb: What kind of indicators do we look into before deciding when these measures can be withdrawn? Was there enough evidence in the case if India?

    RC: At least for India and China and other emerging nations there were definite signals that demand was picking up. The index of industrial production (IIP) was showing double digit growth for 14 out of 17 sectors. Other business confidence indicators like the HSBC Purchasing Managers Index were all giving very positive signals. There was capacity expansion in the industry across sectors. There was enough evidence to say that the domestic economy was picking up. Also, once demand starts picking up managing inflation only becomes tougher.

    tejas@iimb: Where do you think the Indian economy would have been if these expansionary measures were not introduced at all? Where do you think the Indian and world economy will be in six months time?

    RC: One thing we need to realize is that there were not many stimulus related measures from the government. There were measures from the RBI to infuse liquidity in the system and lower interest rates but there was not much from the fiscal side. Measure like NREGA, loan waiver for farmers, the Sixth Pay Commission hikes were already on the cards. It was probably just good timing, with elections around, that the economy got the unintended boost. Though the demand in India looks to be strongly rooted right now, in case of the world your guess is as good as mine. It looks like it’s going to be a slow recovery. We are not going to see pre-crisis levels for another 3-4 years to come.

    Causes of Inflation

    tejas@iimb: Inflation is no doubt very high, but to what extent do you attribute it to monetary policies considering the fact that banks were conservative and actual lending did not see an expected increase even when RBI was promoting liquidity?

    RC: In India, inflation has been historically more because of commodity prices. Whenever it peaked, it was because of commodity prices like edible oil, onion, sugar, etc. It is hard to say to what extent the loose monetary policy had an impact on inflation. Unlike the west (developed nations) the money market are not very developed in India. The inflation is more a reflection of the lack of agrarian reforms and to some extent increased consumer spending because of the Pay Commission hikes or the NREGA.

    tejas@iimb: There is a theory that claims that an expectation of imminent interest rate increase has fuelled the demand of durable goods including cars, etc. This in turn leads to increased demand of money and thus inflation. What are your thoughts on this?

    RC: I do not agree. We can clearly see that barring a few there has been a rise in demand across all sectors. This is not because of perceptions of increased interest rates but as I mentioned due to the huge spending boost across India because of the Pay Commission and NREGA. Also, durable goods typically and expectedly see higher rise in demand than everyday consumer goods because of increased income.

    tejas@iimb: A major cause of the increasing inflation is inflationary expectations. How do you think the government and RBI are tackling this? What kind of signals should they be giving?

    RC: The RBI has been definitely giving signals over the past two quarters. As mentioned, SLR has been lowered CRR has been lowered. The government, on the other hand, has been giving mixed signals. They discouraged the tightening measures taken by RBI. The government has not been very prudent about its spending. Overall, the government has not given the right signals till now. However, it has probably given the right signals in this budget.

    tejas@iimb: What kind of steps should the government be taking?

    RC: The government should focus on agriculture. There has to be a lot more investment in agriculture related infrastructure. India’s policy with the agricultural has been very subsidy oriented. Subsidy as a policy is not sustainable either from the fiscal or the ecological point of view. There has to be more spending on R&D and better quality seeds should be provided. The emphasis has to be put on increasing productivity. Also, we are a major importer of a few crops. Our domestic demand has a bearing on international prices and vice-versa. Considering that inflation depends a lot on commodity pricing, measures have to be taken to achieve food and oil security.

    Measures of Inflation

    tejas@iimb: Inflation presently reports inflation based on WPI. Does this paint a true picture of state of Indian economy? What are the pros and cons of using WPI? Why has India stuck to the use of WPI while most developed countries have switched to CPI?

    RC: No, definitely the WPI does not paint a true picture of the economy. The services sector which is now about 60% of India’s economy is not accounted for in WPI. The base year which has been shifted lately should be shifted every 5 years to give a better picture. Typically, people say WPI gives a lower number than CPI, but that is not the case. We have seen the CPI and WPI crossover on enough occasions. One reason for using the WPI is that we are a supply constrained economy. For the common man, CPI matters while WPI matters for the industrial world. CPI has its own problems, there are too many collection points and a better collection mechanism needed.

    tejas@iimb: What will be the effect of change of base year and change of reporting cycle?

    RC: Yes, the change in base year was long overdue and is definitely a positive move. However, I am not sure about the change in reporting cycle. The problem is in the data collection mechanism and collection points. Increasing frequency can on the other hand increase the noise. There has to be some measure which takes moving average which could reduce noise.

    Policy on Inflation-Growth trade-off

    tejas@iimb: How has India historically handled the inflation versus growth dilemma? Has it focused more on growth overseeing inflation or has it always endeavoured to keep it in a tight leash?

    RC: I think the emphasis has been mainly on growth. The independence of RBI and government has to some extent increased focus on controlling inflation. Even RBI pays more emphasis on controlling exchange rates than inflation.

    tejas@iimb: Indian population is very sensitive to inflation. Whether or not an incumbent government stays in power depends a lot on inflation. Has this sentiment hampered India’s growth potential over the years?

    RC: I am not sure whether inflation has really affected the outcome of elections. One reason for that could be that elections in India are being held all the time in some state or the other. Populist schemes play a much bigger role in elections. People need to realize that inflation is a fall out of these populist schemes. Now that the government cannot monetize its deficits, it has to borrow from the public which can affect long term growth. This is according to me a bigger concern in the long term.


    The cause for infaltion is rooted more in commodity prices than in monetary policies. Fiscal measure like NREGA, Pay Commission Hikes, etc have only increased inflation further.Government should concentrate on implementing agrarian reforms to increase productivity and work on attaining food and oil security to immunize the nation from international volatiliy. The spending in agriculture has to change from subsidies to infrastructure investments. The problem in measures of inflation are mainly becasue of flawed data collectin mechanism. An increased frequency of collection will not help much unless these mechanism are rectified.


    Rupa Chanda is a Professor in Economics and Social Sciences at the Indian Institute of Management in Bangalore (IIMB). She has a Ph.D. in Economics from Columbia University, with a specialization in International Trade, and a Bachelor’s degree in Economics from Harvard University. At IIMB, Dr. Chanda lectures on Macroeconomics and International Trade. She currently holds an institute research chair and was the recipient of the ICFAI Best Teacher Award for 2006. Prior to joining IIMB, Dr. Chanda worked as an Economist at the International Monetary Fund in Washington, DC. She has held short-term research appointments at the World Bank and the United Nations and has been a consultant for the ILO, WHO, UNDP, UNCTAD, OECD, ICRIER, and IIFT. Dr. Chanda’s research interests concern multilateral trade liberalization, the WTO and services, migration, child labour, and macroeconomic stabilization. Dr. Chanda has many publications to her credit. Some of these include, Globalization of Services: India’s Opportunities and Constraints, published by Oxford University Press in 2002 and an edited book titled, India’s Trade in Services: Prospects and Strategies, published by Wiley-India in 2006.


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