INDIA: Is Delhi Capable To Curb Inflation !

India's growth potential will be capped if government spending isn't controlled.

Inflation in emerging economies is on the rise, and nowhere more so than in India, where policy makers are struggling with accelerating, double-digit price rises. But Delhi's ability to handle the crisis is hampered by the fact that Delhi created the problem in the first place.

Reserve Bank Governor Duvvuri Subbarao has clearly been behind the curve. The central bank held interest rates at 3.25% throughout last year and only increased banks' cash reserve ratios slightly. The central bank created more money than there was demand for—and the value of the rupee fell.

As a result, India is now running the highest inflation rate in Asia. Wholesale price inflation reached 9.9% in February...............
, the latest data point, compared to a year earlier. Manufacturing prices rose 7.5%. On a quarterly annualized basis, Indian wholesale prices were up 13%, compared to just 3.6% in China.

In response, the central bank hiked its repo rate—the main policy rate—by 0.25%. But that's a small move that will have little effect on slowing credit creation.

More must be done. Monetary authorities have two main weapons in trying to curb inflation: They can try to increase the cost of capital by raising interest rates or they can try to push up the value of their currency relative to those of their trading partners so that imported price inflation is moderated.

The problem for India is that currency appreciation is not an option. While letting the currency appreciate may help to moderate inflation in Asian economies like Singapore with a huge external trade sector, it has much less effect in India, which is dominated by its domestic sector. A 1% change in the trade-weighted value of Singapore or Hong Kong dollar will affect inflation in those economies by 0.5% within six months. In India, a similar move in the currency would deliver less than 0.2% on inflation.

So that leaves monetary policy. The Bank may be hesitant to raise rates for fear of attracting an influx of short-term foreign portfolio capital, or "hot money," that could fuel asset-price bubbles. India's foreign capital inflows are primarily based on portfolio investment into Mumbai's stock market and other financial assets rather than from direct investment. In 2009, net portfolio inflows were the biggest in ......

18 years. Higher interest rates could attract even more capital.

The Bank may also be gun-shy because Delhi's politicians have racked up the highest government deficit as a share of GDP in Asia. The fiscal balance for the public sector has reached 11% of GDP, now in the same league as the madhouse fiscal balances being generated in sovereign-risk economies of the Eurozone, the United States, Britain, and of course, Japan. If the Reserve Bank raises rates too quickly, it will put too big a burden on the government's debt servicing costs. The public sector will then start to "crowd out" the private sector for funds to invest and grow the economy. And India's growth potential will be capped.

It's already happening. Central government debt exceeds 60% of GDP and consolidated public sector debt is near 80%, very high for an Asian country. Debt servicing now takes up 3% of GDP and 20% of government spending. This running sore on public finances has led to a chronic inability to improve the infrastructure of the economy—thus the contrast between India's vibrant businesses and its hopeless roads, rail and air transport.

So far, the Congress Party-led government hasn't shown much willingness to tackle these problems. Congress raised public-sector wages and promoted large agricultural subsidies to win office again last year. In its last budget, the government announced that it would end fiscal stimulus and targeted a reduction in the central government deficit to 5.5% of GDP from 6.9% for the year just ending. But this excludes off-budget borrowing and depends mainly on asset sales and achieving real GDP growth of 9%. Given that tax revenues are just 8% of GDP, a very low base, boosting tax rates will not do the trick

And we have heard all this before from Indian governments: an optimistic forecast of reduced deficits, while also expanding infrastructure spending. Given that asset sales have always been hard to deliver and that the real central government deficit including off-balance sheet items is more like 8% of GDP, these targets are not going to be met.

Reserve Bank Governor Subarrao is well aware of this conundrum and is no doubt lobbying the government for fiscal prudence. And there are many in the government equally cognizant of what "big government" has done and will do to destroy economic growth. But knowing something and doing something are two different things.

The irony is that India has growth potential even greater than China's. It has the highest household savings rate in Asia at 32% of disposable income, with 65% of annual national savings coming from households compared to under 40% in China.

India also has natural economic growth in that its growth in recent years has come from domestic demand and employment, not net exports. Half of India's annual 7% real growth came from private consumption and less than 10% from external demand. By comparison, about two-thirds of China's average 10% real GDP growth in the 1990s came from exports and export-driven investment; only about 25% from private consumption. India is much less dependent on global demand for its prosperity.

And then there's employment. India's workforce has been growing at nearly 2% a year in the last decade, while China's grew at less than 1% and that growth in China's labor force will disappear in this next decade.

But all these long-term structural advantages contrast with appalling public finances and the risk of credit-fuelled inflation. Much firmer policy action is needed to reduce the size of government and its profligacy. If action is not taken soon, then the government's target for nominal GDP growth of 12%, made up of 9% real growth and 3% inflation, will look increasingly silly. At best, it will be met by a much higher proportion of inflation than real growth; at worst, growth will pared by the need to curb inflation.

Source:WSJ (David Roche)