(this has just been moved to blogger.written sometime in july 08.This was published in I.C.W.A. AUG newsletter.)
The greatest challenge that the B.R.I.C. economies face today is of overcoming barriers to growth, most important of which is inflation and this has been fueled by a steep increase in oil prices which is expected to rise further in near future.
Contribution of oil price rise in inflation in world economy can be gauged from the fact that crude oil was trading at about 42 $ per barrel in 2004 which increased to about 53 $ per barrel in 2005, 64 $ per barrel 2007 and now in 2008 prices are rising almost everyday (crude oil was trading at almost 140 $ per barrel as of 30th June 2008). Further, inflation that Asian markets are facing today is also not an unexpected one. Its roots can be traced back to summer of 2007 with sub prime crisis, in response to which FED cut key interest rates sharply. These cuts were inappropriate for India as the Indian economy was growing full out in 2007 and the last thing it needed was lower interest rates in U.S. With relatively lower interest rates in U.S. India experienced large capital inflows and rupee appreciated against dollar. With rupee appreciating more strongly against dollar Indian economy which needed demand restraint got demand stimulus instead and thus there is a strong argument that inflation has been exported to India from U.S. Thus even without crude oil price rise, bad weather, speculation in commodity exchange markets and ethanol
programs there would have been considerable inflationary pressure on India. The above mentioned factors have simply escalated the magnitude of inflation in India. But these things could have been thought of well in advance.
The question to be asked be asked is what sort of policies should be adopted by countries like India for controlling inflation without compromising on growth. Further is their a choice to be made between inflation control and growth, can both the goals be attained simultaneously?
Well the answer is not a straight one. Let us look at possible solution.
We require coupling of both contraction of monetary policy and expansion of fiscal policy to form a revolving door for escaping demons of inflation with growth rate intact.With rise in interest rates we can choke off the demand for credit thus reducing expenditure and controlling prices. An expansionary fiscal policy on the other hand with instruments like increasing public spending would insure that demand does not collapse altogether. There are 4 basic components of AD namely Consumption spending (C), Investment spending (I), Govt. expenditure(G), Net exports (NX).With a tight monetary policy, cost of borrowing increases thus households reduce consumption spending thus with decrease in demand,prices are controlled and inflation is taken care of, however at the same time due to a tight monetary policy investment spending also reduces and this leads to a negative effect on rate of growth of an economy. To counter this, fiscal expansion has to occur simultaneously under which govt. spending has to be inc. especially in development of infrastructure and human capital. This prevents sacrificing growth altogether for controlling inflation. Thus with this simultaneous use of fiscal expansion and monetary contraction we achieve the basic target of inflation control without compromising on growth. In case of India however this revolving door is jammed. To inc. govt. spending (fiscal expansion) we have to have a budget surplus but owing to populist policies like loan waiver to farmers, pay hike by govt. has lead to a situation where India has one of the highest budget deficits in Asia thus making it almost impossible to negate negative effect on growth rate due to monetary contraction through a measure like fiscal stimulus. China on the other hand has a huge budget surplus which will allow use of revolving door and an appropriate fiscal policy will see them through this time of world economic crisis.It is true that a ruling govt. has to pay attention to welfare of its people but the way in which this objective has been targeted is the least efficient one.
LOAN WAIVER FOR FARMERS
This loan waiver is estimated to cost govt. exchequer about 73,000 crore rupees. But will this permanently end the unabated suicides and bankruptcy of Indian farmers? The
answer is a clear NO. The real need is to help the agriculture sector and not the individual farmers.
If you put this money in developing protected agricultural practices,drip irrigation
facilities, creating aggregators for the farmers to play in the Futures market, get easy credit facilities available to farmers and teach them the modern farming methods, they will manage the rest. This policy of govt. is a moral hazard which would promote higher inefficiencies among farmers who will have little incentive to innovate or perform optimally with available resources. Further, this has set a really bad precedent under which farmers would always expect such steps from govt. in election season. Besides this many farmers borrow money from moneylenders. What will happen to them? Doesn’t state in itself have a responsibility of getting credit facilities available to poor farmers and also create awareness to help them in adoption of efficient production methods? Farmers borrowing money from moneylenders is a testimony to lack of credit facilities in rural India. What in this policy is the incentive for an honest farmer who has not defaulted on paying the borrowed amount?
With land becoming a scarce commodity, the only way for a country to prevent food
shortage is to substantially increase the crop/acreage of farming. Neither the finance ministry nor the agricultural ministry seems to be concerned about long-term solution. The politics of opposition, coalition has brought the ruling parties to its knees on more than one occasion. Given the multiparty system we possess, it is very unlikely that a breakthrough in any sort of policy making would be achieved anytime soon. Thus every time a ruling party will engage in populist policy to expand its vote bank rather than using its reserves efficiently and this eventually will lead to an economic crisis as each economy has a business cycle. There are times of economics expansions where a country must develop huge budget surplus to overcome recession periods in which it would have fiscal deficits. Thus balancing of budget over a business cycle is very important. But we, owing to populist policies will have huge budget deficits by the time the recessionary phase in economy arrives.
PAY HIKE
Under the recommendations of the 6th pay commission the government’s wage bill will expand by around Rs.79 billion (around $2 billion) during the next fiscal year with an additional one-time burden of Rs.180 billion ($4.5 billion) as per official estimates. To say the least these pay hikes are uneven. What was required of this pay hike was to establish some sort of equality and improve living standards of majority of people employed by the govt. of India. About 74 % of people employed by govt. of India are in defense and police forces but the major pay hike of about 40 % has been proposed for bureaucrats. Hence it would not be wrong to say that though
pay hike was required but the way in which this rise in slabs has been allocated
is disappointing. It should not be forgotten that development of human capital
is the need of the hour with innovation being the key to increasing productivity. What was required of this pay commission was to improve salaries in defense and police services along with educational institutions and health care institutions to prevent brain drain and attract the best of talents from world over but this pay hike mainly comes through as a hike dedicated to bureaucrats.
DAMAGE CONTROL
It is quite clear that India owing to interference of politics in policy making will have to pay up if the same trend in world economy continues. A tight monetary policy
will have to be used to control inflation and growth will have to be sacrificed as we cannot use an extensive expansionary fiscal policy due to enormous fiscal deficits. Today oil is a major input and rise in its prices results in increase in prices of finished good in both primary and secondary sector. With the growth trend that India has shown in this decade the purchasing power of an average Indian consumer has increased and given the large population base,containing the ever increasing demand for oil would be very difficult. But given our limited production capacity and an exploding demand for oil, efficient use of such scarce resources has to be promoted. Under this huge subsidies on oil have to be done away with. Crude oil which costs $ 140 per barrel as of 30th June 2008, in India still translates to barely $ 60 per barrel. This has lead to explicit and implicit subsidies to consumers of about Rs. 2,45,000 crore. The recent hike in prices of petrol by Rs 5/litre, diesel by 3/litre and cooking cylinder by Rs 50 are by no means substantial ones, thus the opportunity cost of investment of oil companies is quite huge to say the least. Further this increase in prices have also been partly cushioned by cuts in excise and custom duties by central govt. and cuts in VAT by state govt., yet political parties across India are staging protests against this and trying to use this as a platform for general elections, critically ignoring the fact that if they come to power they will also face similar issues and then their opposition will take them to task in a similar manner. Politicians in India are of the view that higher oil prices are fault of govt. not global trends. Critics argue that estimates of oil subsidies are exaggerated. According to them petroleum products and oil companies have been making good profits so now these companies should pay up during the times
of high inflation to protect consumer’s interests. The same critics however blame west for carbon emission and global warming, yet wish to subsidize India’s own contribution to the same. Majority of developing countries are facing resistance against inc. in oil prices but it cannot be denied that this is a time to rise above politics of oil and take some strong actions. For example after a long freeze on oil prices, Malaysia has just hiked its oil prices by 41% and Indonesia by 30 % thus the fact that prices of oil needs to be linked more to market mechanism has been recognized by some developing countries.
Some people share the perspective that scenario in India cannot be compared to that in U.S.as the latter one is a developed economy and it is due to this fact that they can afford to link prices of oil directly to market mechanism. In India there is a large section of population which is still quite poor and needs help of govt. to improve upon their living standards. But this does not mean that we subsidize fuel for all the people of the country irrespective of the section of population (rich or poor) they belong to. An IMF study of 5 emerging economies shows that richest 20% of the people got 42 % of oil subsidies and the bottom 20% accounted for less than 10 % of oil subsidies. It should not be forgotten that these rich section of society are the ones who engage in wasteful purposes like driving low mileage cars etc. Thus clearly the thought that rise in oil prices will hurt poor the hardest is a misconception. Subsidies do play an important role in a developing economy but they have to be targeted efficiently.
According to basic economics price of any commodity is determined by supply and demand of product. When demand increases prices go up, higher prices lead to decline in consumption demand and eventually this leads to a fall in prices.However this mechanism is not followed in a commodity like oil. This is because many govt. subsidize oil consumption thus keeping demand of oil artificially high.Due to this
excess demand the world oil prices are artificially high. This leads to a paradox. Each developing country believes it is subsidizing its own consumers but when many developing countries do so, especially the ones with a large population base, they push the global prices up due to high artificial demand and thus have to subsidize even more (in terms of value) due to higher crude oil prices and hence subsidy-crude oil price spiral comes into effect. Thus countries which subsidize oil become victim of their own subsidy in the long run. The demand for oil in rich countries is slowing today with rising prices.
Petrol consumption has fallen in U.S. as the prices have risen to $4/gallon. Oil prices in Canada are based on real time pricing of crude oil in world market thus prices can change a few times with a span of a few hours. In these countries demand for gas guzzling cars has collapsed. All these positive outcomes flow from passing on the burden of high oil prices to consumers who then opt for efficient use of oil and related products. But China, India and many developing countries through their oil subsidy program have tried to keep oil prices artificially low thus have kept demand artificially high and it is partly due to this reason that the crude oil prices have skyrocketed. This is the reason why OPEC is able to sell oil for 140 $ per barrel despite a global slowdown. Thus what can be done is as follows-
1.All steps should be taken to prevent subsidizing oil. However if under political pressure oil has to be subsidized then we have to go for price discrimination so that the poor section of the society can avail benefit from it and not the rich. Ideally this can be done by discriminating on basis of income but there are several loopholes in the system so we should rather discriminate on basis of segment of cars, charge more from people owning huge fuel inefficient cars and charge less from others and also fix a quota so that they do not engage in wasteful purposes. We can also have separate filling stations for commercial and personal vehicles and then use price discrimination which can then lead to efficient consumption petrol and diesel.
2.Improve public transport system and offer incentives to people who use it. A lot has to be done in this regard. To reduce emissions C.N.G. program should be made mandatory across states and an effective strategy to offer incentives to people who use public transport has to be worked upon. Besides this the parking fees which are too low in India in comparison to other developing economies should be hiked so that people pay serious thought before using personal vehicles.
3.Ideally India should pass on the full cost of fuel to consumers as is done by most of the developed countries. But this would ask too much of our politicians whose logical reasoning seems to begin with effect on vote banks.For this Mr. Swaminathan has proposed a solution in his weekly article in the times of India dated 8th June 2008. “What can be done is that all implicit and explicit subsidies on fuel should be abolished and money saved from this should be used to cut excise duties on other items of common consumption and provide cash to poor families. Overall inflation and Govt. revenue will be unchanged in short run, yet the poor will benefit and high oil
prices will encourage energy efficiency”. India’s oil use will fall thus lowering world demand and thus lowering crude oil prices. Lowering of crude oil prices will definitely reduce the budget deficit in the long run given the fact that oil today is a major input in production of mostly all primary and secondary commodities and also accounts for the transportation cost which eventually affects the selling price of a commodity.
