year 2012 appears to have begun well for India's economic
policy establishment. Food price inflation, measured
on an annual week-on-week basis, which was hovering
for many months in the two-digit range, has not just
moderated but turned negative. And there are signs
that the continuous decline in the annual, month-on-month
growth in the Index of Industrial Production (IIP)
was reversing itself as of November. Low inflation
and growth, even if moderate, should cheer a government
that feared stagflation till recently.
However, not everybody is enthused by the evidence.
Inflation is not just confined to food articles. And,
even in the case of food, there is good reason to
believe that the decline in prices is because of the
''base effect'' that plagues week-on-week rates. Inflation
rates in any particular week could rise or fall partly
because the price index in the corresponding week
of the previous year was either unusually low or unusually
high. Moving out of exceptional periods of that kind
can restore the trend, which in this case is estimated
as positive and reasonably high, even if not in the
10 per cent-plus range.
Similar doubts have been expressed with regard to
the IIP, which has shown unusual volatility in recent
months, though the trend seems to be one of decline.
The ‘V-shaped' recovery from the 2009 recession seems
to have peaked and reversed itself as far back as
February 2010. That was disappointing enough, because
the recovery had established India as one among the
countries that had quickly put the effects of the
global crisis behind it. What is even more disconcerting
is that subsequently industrial growth slipped, stabilised
for a while, and then registered a sharp downturn.
Some believe that the return to a 5.9 per cent growth
rate in the month of November may indicate an end
to the slowdown. But others prefer to hold back on
the grounds that it is too early to arrive at that
Despite these uncertainties, the financial media,
the private sector and sections of the government
are attempting to make much of the end to stagflation
and demanding an early response. They are calling
on the central bank to reverse its policy of hiking
interest rates to deal with inflation. The central
bank through 13 hikes over close to two years had
raised its reference rate by more than 3 percentage
points. This has resulted in higher borrowing costs
for all except the big corporates, who can access
international credit under the liberalised policy
of the government. To that extent it may have adversely
affected investment among small and medium businesses.
But more important is the effect higher interest rates
are having on household spending. Encouraged by the
central bank's easy money and low interest rate policy,
Indian households have in recent years relied substantially
on credit to finance investments in housing and purchases
of cars and durables. The resulting increase in demand
was an important factor pushing industrial growth.
With interest rates being raised in recent months,
this source of demand has been affected adversely,
contributing in no small measure to the slowdown.
Thus, reversing the interest rate hike is seen as
crucial for growth. And the deceleration in inflation
rates is seen as affording the opportunity to restore
interest rates to acceptable levels.
Even accepting the view that the fall in inflation
rates and the rise in industrial growth rates are
not statistical phenomena but reflective of a sustainable
trend, this argument misses out on important features
of the current conjuncture. The period since 2003-04,
till the crisis of 2008-09, was an exceptional period
in India's post-Independence growth trajectory. Not
only did the country transit to a much higher, 8 per
cent-plus, GDP growth trajectory, but there were signs
that finally industry and agriculture, besides services,
were contributing in some measure to that growth.
More importantly, this high rate of growth was not
running up against serious supply side constraints
and resulting in inflation. Rather growth was occurring
in an environment of relative price stability. This
combination of high growth and low inflation is indeed
the capitalist dream, reminiscent of the post World
War II Golden Age in America. Poverty and deprivation
remained unacceptably high no doubt and employment
was hardly responding to output increases, but there
was more than a little to please the government.
To appreciate the significance of this combination
of high growth and low inflation we need to turn to
India's pre-liberalisation, post-Independence history.
For long, India was seen as a country that walked
the tightrope between food price inflation and balance
of payments difficulties. When growth tended to accelerate,
pushing up employment, wages and the demand for food,
it ran up against a supply bottleneck in the country's
still backward agricultural sector. Food price inflation
followed, forcing the government to cutback on its
expenditures and rein in demand in order to dampen
inflationary trends. Simultaneously, high growth increased
the import bill of the country that was not too successful
an exporter and had limited access to foreign capital.
The resulting balance of payments difficulties meant
that scarce foreign exchange could not be used to
finance imports that would relax the supply constraint
and held curb inflation. On the contrary, even without
such imports the country faced periodic balance of
payments crises. Thus inflation and balance of payments
difficulties constrained growth to moderate levels,
and the national output fluctuated around that moderate
It was in the 1980s that it appeared that India had
partly overcome these problems. As a result of changes
in the global financial system, the country obtained
greater access to foreign finance in the form of debt
and foreign investment flows. This encouraged the
government to ramp up its spending, leading to the
first signs of a shift out of the so-termed ''Hindu
rate of growth'' of 3-3.5 per cent to a GDP growth
trajectory of more than 5 per cent per annum. If inflation
was a threat, easily accessible foreign exchange could
be used to augment supplies through import and rein
in prices. However, being based on a sharp increase
in borrowing from abroad in a world that had already
experienced the Latin American debt crisis, this trajectory
proved unsustainable. Foreign lenders and investors
turned wary and reduced India's access to foreign
finance, making it difficult for the country to meet
its foreign exchange payment commitment. The result
was the balance of payments crisis of 1991 that temporarily
terminated India's high growth trajectory.
What was remarkable, however, was that despite the
crisis, the search by cash-rich foreign investors
for new markets combined with India's liberal external
policies to ensure continued access to foreign finance.
Soon growth resumed at rates similar to that achieved
in the 1980s.
But that growth was volatile, touching high levels
during 1993-94 to 1996-97 and then tapering off and
slowing down by the turn of the century. It was only
after 2003-04, as noted above, did the economy experience
acceleration, leading to the high growth trajectory
that India has become known for in recent times. That
growth continued without creating balance of payments
difficulties because of large receipts from remittances
and software exports and because of capital inflows
far in excess of India's needs. It also did not result
in domestic inflation, partly because India was still
partially insulated from global price trends and partly
because the nature of growth was such that it did
not result in substantial increases in demand for
food and agricultural products.
However, over time there was one unexpected development
that this growth seemed to culminate in: generalised
inflation, with food price inflation being particularly
high in some periods. One reason for such inflation
was of course the long years of neglect of agriculture.
Rapid non-agricultural growth in a context of slow
agricultural growth or even agricultural stagnation
must finally lead to price increases due to imbalanced
growth. Yet, overall, it did not seem to be the case
that inflation was primarily the result of demand-supply
imbalances. Rather, inflation appeared to be substantially
the result of cost push factors, with costs rising
because of rising import costs, cuts in subsidies
and a growing tendency to calibrate administered price
increases to correspond with international prices.
All these were in keeping with the ideology of economic
reform. The area in which this was most obvious was
oil, leading to much controversy. But it was true
of price trends for a range of inputs and intermediates,
and therefore affected final product prices. It was
also true of the minimum support prices at which food
grains were procured. The outcome was, of course,
that growth was accompanied by high inflation, since
India had become an economy characterised by rising
costs and rising prices. This was the other side of
the policy of liberalisation, which permitted high
growth supported by access to foreign finance.
Two features of this growth process and their implications
need noting. First, growth during the first decade
of this century was driven not by public expenditure
but largely by debt-financed private expenditure.
Second, this was the period when, as a result of fiscal
reform, the government was trimming its fiscal deficit
to GDP ratio, unlike during the 1980s when that deficit
widened significantly. The implication of the implicit
substitution of debt-financed private spending for
debt-financed public spending as a stimulus to growth
was that the government was less willing to curtail
its expenditures to address the inflation problem.
In the event, the task of dealing with inflation devolved
on the RBI, which resorted to the conventional weapon
used by central banks by raising interest rates repeatedly.
But this, as noted above, adversely affected debt-financed
private expenditure, resulting in the growth slowdown.
Households daring to borrow when low interest rates
made monthly instalments of debt affordable now withdrew
from the market. As a result, India once again seems
to be in a world in which sustaining growth with low
inflation is difficult to realise. If inflation has
to be reined in, it appears, growth had to be sacrificed-a
conclusion that is unacceptable to a government obsessed
with GDP growth.
It is for this reason that the early signs of a reduction
in the rate of inflation have been received with much
enthusiasm and the evidence used to make a case for
lower interest rates. There is no reason to believe
that within the current policy regime this would not
aggravate inflationary trends once again. The rate-cut
recommendation ignores the possibility that the problem
at hand is structural, and that demand compression
is a prerequisite for moderate inflation. If that
is the case the high growth-low inflation mix that
makes India's economy ''shine'' will have to give
way. And the many stains that should mar the appearance
of the current growth trajectory may come to the fore.
This article was originally published in Frontline,
Vol. 29, No. 02, Jan 28 - Feb 10, 2012.