The Hindu : Business : Signs of stress call for close watch on economy

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Monday, Nov 01, 2004

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Signs of stress call for close watch on economy

Attributing the inflationary pressures entirely to oil supply shocks is not borne out by empirical analysis of variables, says S. Narayan.

THE CREDIT policy announced by the Reserve Bank of India has to be seen in the context of macroeconomic indicators in the country and global growth prospects. The weak monsoon has resulted in deficiencies of rainfall in 38.4 per cent of the area, but current indications are that there is unlikely to be a drop in agricultural output. Given the lower level of buffer stocks, the higher scale of procurement will ensure liquidity with the farmers which may help demand growth in the rural sector.

At the same time, strong growth in industry and services is visible. Quarterly GDP growth touched a peak of 10.2 per cent in the third quarter last year, and has been over 7 per cent in the first two quarters. Industrial production is growing at just under 8 per cent, up from the 2 per cent growth figures of 2002. There is a healthy growth in trade though, of late, high oil prices have led to a worsening current account balance. Exports continue to be buoyant, growing at under 20 per cent over last year.

The year 2004 saw India as a significant exporter of automobiles and there is a distinct opportunity for the country to emerge as the largest supplier of small cars to the world, with attendant benefits for the ancillary and other light engineering industries.

The growth of trade in goods and services year-on-year is more than 30 per cent, a level not matched by even five other countries. Net capital inflows continue to show quarterly growth of more than 5 per cent up to the second quarter this year.

Importantly, there seems to be a better balance in forex inflows and outflows, with the RBI's net purchases at levels low enough to be comparable to year 2000, when forex reserves were only around one third of the present levels. NPA figures of banks are down, and industry is reporting healthy half-yearly results.

Impact of costly oil

Yet beneath all this cheer is the nagging doubt, like that of the character Vitalstatistix in the Asterix comics, of when the sky will fall on our heads. There are certainly causes for concern which have been pointed out, quite softly so as not to ruffle anyone, in the recent credit policy.

The first is the concern over rising oil prices. Much of the rise in prices seems to be persistent and unlikely to reverse meaningfully (by more than $5-8 a barrel) in the near future. As such, it is likely to have a considerable bearing on monetary policy responses worldwide.

In India, where dependence on imported crude is over 70 per cent, the impact is likely to be quite significant. The trade deficit is likely to widen considerably through terms-of-trade effect, with the chances for a doubling in merchandise account deficit being quite real.

Since the transmission of international prices to domestic prices is not one-to-one, as the Government and oil companies share most of the burden initially the impact on growth may not be much.

However, if growth slows down globally, the second-round effects on export demand and the impact of delayed but inevitable adjustment of domestic prices are likely to take a significant toll, though quantification of this is difficult at this stage.

Further, if oil prices continue to rise, these will be passed on by way of increased prices in the domestic market.

Local factors in inflation

This leads to the other major concern, namely, inflation. The RBI has softly but firmly asked the Government to do something about it.

However, attributing the inflationary pressures entirely to oil supply shocks is not borne out by empirical analysis of variables such as manufacturing inflation, money supply growth, non-oil imports, credit demand, and capital goods and durables production. Analysts have pointed out, for example, that inflation in capital goods prices in the wholesale price index (comprising machinery and machine tools and transport equipment and parts) has been steadily inching up and has reached a three-year high of 5.9 per cent.

It is definitely possible now to argue that easy monetary conditions, apart from higher fuel prices, have also contributed to the rise in inflation and considering that the official short-term rates are way below the underlying trend in inflation (believed to be between 6 and 7 per cent), there is a need to normalise the policy stance. The Reserve bank has left interest rates unchanged and this itself is a cause for worry.

The third concern is that of fiscal deficit and government borrowings. It is clear that holding interest rates and consumer prices of oil products can only be temporary solutions to contain inflationary pressures.

The political approach to easy credit in general and liberal credit to the agricultural sector in particular will probably continue, and there is very little effort to mop up the excess liquidity in the economy.

At the same time, the RBI has admitted that nearly 50 per cent of governmental borrowing has been completed by October and that further open market borrowings will have to be `calibrated.'

Yield rates have risen and the RBI circular allowing banks greater flexibility in holding securities to maturity is only a measure to safeguard their balance sheets from the shocks of correction.

Finally, adding to the pressure are the demands on the Finance Ministry by different ministries and the Planning Commission for larger public spends, ostensibly for the Common Minimum Programme agenda.

Food stocks are low, and procurement will need increased credit. The Government has already not been able to live up to the commitment made on borrowings up to September while revenue authorities are on a major collection drive whose effects may not always be positive. If all adjustments are to be postponed to the next year, adjustment shocks could well be severe.

In whatever manner we look at it, there are signs of significant stress in the economy. Even the rate of growth of forex inflows has come down and, unlike last year, the weakening of the dollar is not leading to a corresponding strengthening of the rupee. Recognition of these stresses and corrective measures are necessary.

It is imperative that oil price adjustments are made through a mix of tariff reductions and pricing policies. There is also a need to more closely monitor increases in prices and to take correctives. The most important policy concern at this stage should be inflation and there should be clearer articulation of policy.

S. Narayan.

(The author is former Finance Secretary and Economic Adviser to the Prime Minister)

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