The good thing about India’s challenges with rising inflation is that nobody is in denial. The government realizes that short-term policy responses, such as raising interest rates, are not enough. Long-pending infrastructural constraints, like a broken agricultural produce distribution system, need to be fixed. Banks have to address a widening credit-deposit ratio by making deposits more attractive to lure household savers. Amid all this, as stock markets and investment flows recoil, the big worry is that tighter credit could stall India’s growth story. The Reserve Bank of India (RBI), India’s central bank, is getting kudos for making the right policy calls in its bid to contain liquidity and demand without choking industrial investment. But it cannot do it all alone, and needs the government to work in concert with it, experts tell India Knowledge at Wharton.
Admittedly, India is taking a one-two punch: Its problem with rising prices is reverberating across the nation’s kitchens and boardrooms, and that comes as the country refuses to accept corruption in public policy-making as a fact of life. Corporate chiefs like Wipro chairman Azim Premji talk about a “governance deficit” in open letters, and India’s Prime Minister Manmohan Singh lists inflation and corruption as obstacles to faster growth. The benchmark Bombay Stock Exchange sensitive index (Sensex) lost 12.2% in January, led in part by foreign institutional investors (FIIs), who sold nearly Rs. 7,300 crore (US$1.5 billion) worth of stocks that month. It didn’t help that foreign direct investment (FDI) in India also fell in 2010, exacerbated by what many see as overzealous environmental regulation stymieing industrial projects.
In early February, Singh said that even as the economy is seeing high growth, inflation posed “a serious threat.” Food inflation hit 17% in the third week of January, while the wholesale price index rose to 8.43%. But Singh’s government can do little in some areas like easing tax levies on food because agriculture is a subject that state governments control. State laws require all agricultural products to be sold only through government-regulated markets. These markets levy taxes and fees that the central government wants dismantled. States also do not allow farmers to sell their produce directly to buyers; they have to do that through market traders. Singh told a meeting of state secretaries that he wanted them to waive mandi (market) taxes, octroi and local taxes, “which impede the smooth movement of essential commodities.” Meanwhile, global prices of dairy products, sugar and cereals are expected to keep rising amid drought and floods in Russia and Argentina and tensions in Egypt and Tunisia, the Food and Agriculture Organization says in a February report.
In its quarterly monetary policy review in late January, the RBI signaled higher interest rates. It increased by 25 basis points the “repo” (or repurchase) and “reverse repo” rates, which the central bank uses to borrow money from other banks and vice versa. It also indicated that if required, it might increase interest rates again later in the year. (Many market watchers had expected an increase of 50 basis points.) Banks adjusted their lending and deposit rates soon after the policy announcements, depending upon demand-supply factors in specific markets like corporate credit, home loans or auto finance.
Things won’t get better any time soon on the inflation front, according to RBI governor D. Subbarao. In his policy review Subbarao says that while the current spike in food prices is transitory, food inflation could stay high because of structural demand-supply mismatches in several non-cereal food items such as pulses, oilseeds, eggs, fish, meat and milk. Non-food manufacturing inflation is also “significantly above” its medium-term trend of 4%. Going forward, the overall inflation outlook depends on how food and non-food commodity prices move at home and globally, and their impact on industrial raw materials and wages. Subbarao points also to a recent government move that increases cash in the hands of rural folk by linking inflation to wages under a popular rural employment guarantee program. Many economists feel it is untimely.
Subbarao sums up his challenge: “Manage liquidity to ensure that it remains broadly in balance, with neither a surplus diluting monetary transmission nor a deficit choking off fund flows.”
Protecting the Growth Story
Is India’s economic juggernaut of 8%-9% growth in GDP (gross domestic product) about to get derailed? Arvind Panagariya, professor of economics and the Jagdish Bhagwati professor of Indian political economy at Columbia University in New York City, disagrees. “The general sense is that the growth story is going to continue,” he says. India, he points out, has seen high inflation in the first half of the 1990s and in the 1980s. “I get less perturbed by inflation; I would be [perturbed] if it goes beyond 15%. Obviously, hyper inflation will impact growth, but we are nowhere near that.” Panagariya, who wrote the 2008 book India: The Emerging Giant, says that India’s growth is determined by other factors, such as the country’s relatively high savings rate of about 35% and a more productive and globally open economy. He has no worries on those fronts, and looks beyond “short-term bumps” for comfort. “If industrial growth goes to 12%-13% for three months, we feel we have broken the barrier, and if it goes down to 2%-3%, we get upset,” he says. “But look at the long-term trend: Industrial growth has picked up at 8%-9% [and] services are growing faster.”
Impact of Costlier Money on Industrial Projects
According to Ajit Ranade, chief economist at the Aditya Birla Group in Mumbai, higher interest rates are not hurting industrial projects already committed with capital expenditure (capex) approvals and longer pipelines where spending is spread over 18-24 months. “You can’t deny that underlying national income is still growing and you are not seeing growth slackening,” he says. “So there is a reasonable amount of optimism to continue investing.” But he warns that there could be some caution in capex commitments for completely new projects. Ranade believes that for investor confidence to stay high, industrial growth needs to move up to 9%-10% from the current average of 8%. “High inflation is a big risk; it will dampen demand…. But if you include public sector capex — pegged at a trillion dollars in the next five years — industrial investments will still be high,” he adds.
Industrial projects will take “short-term impacts where project costs will go up,” says Mukesh Khandelwal, president, corporate advisory services, at Feedback Ventures, a Gurgaon-based advisory services firm specializing in areas such as transportation, energy, urban infrastructure and health care. Equity and debt rates will also readjust, he adds: “Most lending is typically subject to resets every three years.” Khandelwal’s concerns are about the “larger, longer-term impact” of interest rate uncertainty on infrastructure projects, which are typically funded over a 10-15 year cycle. “The larger impact would be to depress investor sentiment,” he says, adding that it may not be very visible immediately. Also, industrial projects could draw comfort from the fact that prices of commodities like steel and cement have not risen as much as those of foodstuffs.
Policy makers need to watch out for a “price wage spiral,” where higher demand for wages feeding into higher prices will increase input costs, says Renu Kohli, a former staff economist with the International Monetary Fund and the RBI. Kohli now consults independently on macroeconomic issues with foreign investors interested in India. “Since margin pressures are already building up due to higher prices of raw materials, commodities, etc., these will be passed on to consumers, affecting consumer spending,” she says. “On the other hand, the increase in the cost of production and lower profits [on account of lower margins and reduced sales] will impact corporate earnings and investment spending.”
FDI and FII Flows
Amid all those concerns comes an unexpected surprise: India appears to be getting left behind in FDI inflows. FDI flows into India in calendar 2010 fell 31.5% to US$23.7 billion, according to preliminary estimates by the United Nations Conference on Trade and Development (UNCTAD). However, developing countries as a whole attracted some US$525 billion in 2010, up nearly 10% from the previous year. The other BRIC countries too received more FDI in 2010 compared to 2009 — China (US$101 billion), Russia (US$39.7 billion) and Brazil (US$30.2 billion). “Breaking this general upward trend, South Asia experienced a 14% drop in FDI, mainly due to declines in flows to India,” the report says. Global FDI flows were mostly flat in 2010, up 1% to US$1,222 billion, but that was after a 39% crash in 2009 from the 2008 total of US$1,700 billion. Unlike other developed countries, the U.S. saw FDI inflows grow 43% to US$186 billion in calendar 2010. Incidentally, Ranade feels India’s FDI tally for the full fiscal year (through March 2011) will actually show an upsurge to US$45 billion or thereabouts, reflecting a rally in the second half of the fiscal year.
It is not inflation that is scaring away FDI inflows, but the country’s environment policies, according to the RBI. In the first half of the current fiscal year (April-September 2010), FDI in India fell to US$12.6 billion from US$19.8 billion in the same period a year earlier, the central bank said in a report last month. “A major reason for the decline in inward FDI is reported to have been the environment-sensitive policies pursued, as manifested in the recent episodes in the mining sector, integrated township projects and construction of ports, which appear to have affected the investors’ sentiments,” the report noted. The environment ministry, headed by Jairam Ramesh, has blocked several projects, including the Vedanta Group’s mining and refinery expansion plans, alleging environmental and ecological violations.
Getting the House in Order
“We need to get our house in order, not just for foreign investment but also for domestic investment. The environment ministry interferes with every single project,” says Panagariya. He cites the example of the recent environmental approval for a US$12 billion steel project in Orissa promoted by Korea’s Pohang Steel Co. (Posco); it has 60 conditions. These include unusual conditions, such as a pledge by the company to voluntarily sacrifice water intake to facilitate irrigation. “What kind of country and regulatory regime do we have?” asks Panagariya. “We used to complain about World Bank [conditions] being a long laundry list. This sort of approach — to micromanage — is a completely mindless exercise. This is not an isolated thing; there is a systematic pattern.”
Unlike FDI, commitments from foreign institutional investors, or FIIs, are more volatile. Jim O’Neill, chairman of Goldman Sachs Asset Management who is best known for coining the term BRIC (Brazil, Russia, India and China), wrote in his January 29 weekly report: “Within the BRIC equity markets, at current prices, China and Russia are more attractive than Brazil and India.” He cautions BRIC countries experiencing growth and inflation pressures to “slow the momentum of growth in order to support their stronger medium-to-long term outlook.”
All the same, O’Neill is bullish about India in the long term. In an earlier January report, he says, “India has some difficult weeks ahead as it tries to deal with the challenge of inflation as well as a modest balance of payments deficit. But, given the power of their underlying story, even if the current moment might not be the absolute best time to be investing, smart policy behavior will allow this remarkable underlying story to unfold.” He notes that the Indian economy has grown from less than US$500 billion a decade ago to about US$1.6 trillion-1.7 trillion today, adding that going forward, “India is quite likely to grow at a faster rate than China.”
Ketan Sheth, a director of Way2Wealth Brokers, an investment consulting firm based in Mumbai, points out that “Russia is not a comparative market. Qualitatively, it doesn’t have companies comparable with India.” Also, he says some FII investments are “hot money” from hedge funds, quant funds and ETFs (exchange-traded funds) that typically have shorter-term investment horizons. “In many cases, the sudden and swift entry or exit of funds is triggered by a complicated model dependent upon commodities, currency movements and other emerging-market trends. So we suddenly see a large quantum of entry or exit at certain times.” According to Sheth, the alarm over FII pullbacks is unwarranted; FIIs invested US$29 billion in India last year, compared to the US$1.5 billion they sold in January 2011. Although FII inflows could be lower this year compared to last year, they could rebound in the second half as inflationary pressures go down. “Part of the reason investors have turned away from India is they see long-term interest rates going up, says Kohli, pointing to long-bond yields as evidence of that. But she sees respite on that front, if the government’s annual Union budget in late February “signals an anti-inflationary stance through fiscal consolidation.”
Responding to Inflation Concerns
While other emerging market countries like China, Korea and Indonesia are also facing inflation concerns, Subbarao’s policies have mostly won praise for their handling of the situation so far. “The RBI gets high marks from me. They have done a good job. I don’t think they are doing worse than anybody else,” says Panagariya. “They certainly are watching like hawks and they have tightened up monetary policy. It is a balancing act. Too much tightening can have an adverse impact on investment. They have to be careful.” But the RBI may have faced a tougher call than its counterparts in other countries facing inflation, feels Kohli. “Even though RBI was one of the first central banks in the emerging economies to roll back the monetary stimulus, India was the first to see inflation rise very sharply,” she says.
The government, however, gets poor marks for its handling of food inflation. “There is no question the government could have done more on food,” says Panagariya. “You cannot be sitting on 60 million tons of food grains [with] food grain prices rising so rapidly.” Even India’s Supreme Court recently came down heavily on the government for allowing food grains to rot in warehouses, and prodded it to distribute them for free or at subsidized prices to the poor.
Kohli traces the path food inflation took in the past two years. “The 2009 drought was one of the worst in three decades,” she recalls. “Prices were expected to go up, and by April or July 2009, we knew the rains had failed. There was enough time to respond on the supply side, [but that response] for various reasons, was not forthcoming, as in the case of China. Temporary food shortages persisted and there was a lot of liquidity.” The excess liquidity ensured that the RBI’s interest rate increases “did not translate [or percolate into] to the wider economy,” she says.
Kohli also credits the RBI for making the right calls. Inflation raced at above 10% between April and August 2010, and required further action, she says. The “real tightening” began after June-July 2010, when the RBI took advantage of the deficit in the market — the 2G telecom spectrum auctions had caused a liquidity crunch — and effectively tightened interest rates by 150 basis points. “So to the extent of actually impacting the broader economy, monetary action has been a little late: interest rate changes mattered little, as long as there was surplus liquidity.” All the same, Kohli says the delayed monetary tightening “was the correct thing to do, especially as overall economic recovery was still tentative” at that time “and early monetary tightening would have hurt growth.”
According to Kohli, China has been “very swift” in its response to inflation concerns in raising reserve requirements, tightening monetary policy and introducing food price controls. “Given the 2007-2008 experience, when China had also experienced bad weather, its [latest] food management measures were more effective. But you mustn’t forget that it isn’t a democracy like India. Also, in India, responses to food supply shocksdepend upon the states to an extent,” she adds.
Working around Structural Constraints
“High double-digit food inflation is neither recent nor temporary,” says Ranade, pointing out that the average food inflation (about 11%) over the last five years has been twice as high as general inflation rate (5.5%). Some of that, he adds, is because of “structural reasons,” such as changes in demand and consumption patterns, food habits and a general rise in incomes. However, he feels that many aspects could be tackled with policy. Solutions lie in sprucing up the procurement system to enable sales of food stocks in smaller quantities than now permitted, and by allowing farmers to strike deals in the open market, he notes. “Right now, only large traders participate in the auctions or sale of food grains, and they have holding capacity that doesn’t translate into lower food prices.” Other areas where he recommends action: government-administered checks on runaway freight and logistics costs; limits on the “minimum support prices” the government guarantees farmers; food stamps and vouchers to facilitate food grain distribution by private parties; better targeting of fertilizer subsidies to benefit primarily small farmers; and eliminating middlemen like traders. In the current regime, farmers can sell their produce to traders only through government-run markets. “That comes from a mindset that farmers will be exploited by traders,” says Ranade. “But now things have changed enough; we have to see if there is a possibility of eliminating the middleman.”
Experts say that things may have turned out better if politicians had a vested interest in ensuring low food prices. An election year (the next general elections are scheduled to be held in 2014) would have seen more efficient and quicker supply-side management and administrative measures. “The gamble this year has been: With high growth, it is okay if we have a bit of inflation. In an election year, I doubt if such a risk would be taken,” says Kohli.
