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The Danger of a Double Dip

29 January, 2010, C.P. Chandrasekhar

The coming weeks are to witness two important economic policy announcements. The first is the next review of monetary policy due at the end of January. The second is the budget slated for the end of February. These policy interventions would have to contend with what appears to be a mixed picture of the state of the economy. The good news is that the Central Statistical Organisation has put out a reassuring estimate of growth in the economy, with a better-than-expected recovery in the second quarter (July-September) of 2009-10. GDP growth that quarter was placed at 7.9 per cent relative to the corresponding quarter of the previous year. This was not only way beyond growth rates in the previous three quarters when they averaged between 5.8 and 6.1 per cent, but even marginally above the growth rates in the first two quarters of 2008-09 when the effects of the global recession were just beginning to be felt. This sharp recovery has triggered official speculation that growth in 2009-10 would be 7.5 per cent or more, and that India may even see a quick return to the 9 per cent growth trajectory of the five years preceding the slowdown in growth.

The bad news of course is that the overall rate of inflation and especially the inflation in food prices still continue to climb. Even though inflation as measured by the Wholesale Price Index is below double-digit levels (even if climbing), the consumer price index is rising at close to 15 per cent on a month-on-month basis and food price inflation is still close to 20 per cent. These trends on the growth and inflation fronts obviously signal that the problem to be immediately addressed is inflation and not low growth or a recession. Not surprisingly, while one section of the government argues that it is still too early to withdraw the fiscal stimulus it claims to have put in place to stall the downturn, another is increasingly convinced that it is time now to shift attention to holding down inflation by reining in public and private expenditures.

The government's decision to dampen inflation by augmenting supplies to the market through increased releases of stocks it holds and larger imports of commodities like sugar has partly exhausted one of the options it has at hand. If this effort at supply management does not dampen the speculation that is clearly responsible for recent increases in the prices of essential commodities, other measures will have to be sought. These would involve reducing access to credit and raising interest rates in the monetary policy that is to come, and limiting deficit-financed expenditures in the budget for the coming year. Till recently, credit growth has been sluggish in the economy. In fact, as of January 1, 2010, the growth in bank credit was placed at 14 per cent for 2009-10, as compared with the 17.5 per cent recorded in the previous year and the target of 18 per cent set for the current financial year. But more recently there appear to be signs of acceleration in credit expansion. According to figures recently released by the Reserve Bank of India, bank credit rose by Rs. 79,514.51 crore during the fortnight ending January 1, as compared with the average credit off-take of Rs. 21,000 crore in the previous two fortnights. As a result, expectations are that the Reserve Bank of India may mop up liquidity by hiking the Cash Reserve Ratio imposed on banks and raising the indicative repo (interest) rate by anywhere up to half a percentage point.

Similarly, there is no doubt that the budget for 2009-10 would reflect a large fiscal deficit. So though last minute disinvestment may generate some receipts for the budget for 2009-10, the level of the fiscal deficit and the extent of borrowing in that year are bound to be high. This would only strengthen the case being made by those who want contractionary policies to deal with inflation.

The impact that moves of this kind would have on growth is likely to be considerable. A substantial part of the so-called "stimulus" that is expected to generate the fiscal deficit this year was not engineered but fortuitous. With the government having had to set up a Pay Commission for its employees and implement its rather generous recommendations, which involved paying a large amount as arrears, a substantial increase in expenditures was inevitable. What has happened is that, because of the global recession, something that would have otherwise been considered a "burden" that threatened fiscal stability was in the wake of the crisis presented as a necessary increase in expenditure in response to the downturn. If we exclude this unavoidable expenditure, especially the payment of a large amount as arrears for the period from January 2006, the size of the stimulus adopted specifically in response to the crisis collapses. Thus, even if the actual stimulus measures, in the form of tax cuts or increased expenditures, are not withdrawn, central government expenditure would be curtailed at least to the extent that once-for-all arrears payments would not feature in next year's allocations. Since the government has been treating all the increases in its expenditure (during last and this year) as being a consciously adopted stimulus, a reduction in the estimated "stimulus" during the next fiscal is unavoidable. If, in addition, the government chooses to reduce or even keep constant the actual stimulus launched in response to the downturn in the form of new expenditures other than its wage and salary bill, a significant decline in aggregate expenditure that has a countercyclical influence is the obvious consequence. The question, therefore, is whether this would leave the recovery untouched without affecting inflation.

An interesting feature of the recovery in GDP growth in the second quarter of 2009-10 is that, when analysed from the expenditure side, much of it has been on account of an increase in the government's Final Consumption Expenditure. This component in the national accounts is the one which captures the effects of the implementation of the Sixth Pay Commission's recommendation. Its importance can be gauged from the following: The sum total of Private Final Consumption Expenditure, Goss Fixed Capital Formation and Exports which grew at 10.02 and 8.76 per cent respectively during the first and second quarters of 2008-09, registered changes of minus 0.51 per cent and a meagre 2.44 per cent in the first and second quarters of 2009-10. On the other hand, Government Final Consumption Expenditure which registered changes of 0.19 and 2.19 per cent respectively in the first and second quarters of 2008-09, grew at a remarkable 10.24 and 26.91 per cent in the first and second quarters of 2009-10. Thus the recovery was largely the result of an increase in Government Consumption Expenditure, which would fall both because of the absence of the windfall Pay Commission arrears payments in the next fiscal and because of any reduction in the government's stimulus.

Thus, the evidence indicates that, everything else remaining the same, if the government does not increase its outlays in areas other than wages and salaries in the next fiscal, we could experience another downturn. India too seems set for a "double-dip" recession, especially because the expenditure under the arrears head would not be undertaken and is unlikely to be substituted with some other set of outlays. In the circumstances, thinking of dealing with inflation by tightening monetary policy and exiting from the fiscal stimulus may not be altogether a good idea.

What is more, there are reasons to believe that an exit from the stimulus may not be the best way to deal with inflation given its features. To start with, the inflation in food prices has been with us for some time now, including during the phase when growth had slowed. That is, it has been underway even when there has been a contraction in overall demand. Reducing demand, therefore, does not guarantee a reversal of the food price increase. Second, while food price inflation has accelerated after it became clear that rainfall in much of the country during the southwest monsoon was well below its long-term average, the inflationary process began before the failed monsoon. So it is not just the expectation of a decline in supplies that was responsible for the price increase. Third, the inflation occurs despite the fact that foodgrain stocks with the government are comfortable, and well above the buffer stocking requirement. Finally, inflation has occurred even though the country's foreign exchange reserves are comfortable, giving the government the option of importing food to augment domestic supplies and rein in prices.

Given all this, the unavoidable conclusion is that food price inflation is not all the result of inadequate supplies but in substantial measure the result of speculation. What is called for then is not measures that work on inflation by reining in growth, but direct measures to deal with speculators and dishoard their stocks, while augmenting availability through a strengthened public distribution system. This is likely to be more effective and less damaging for the economy. But that does not seem to be the direction the government is taking.



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