Infrastructure: the way ahead

Infrastructure development is a vital component in encouraging a country’s economic growth. Developing infrastructure enhances a country’s productivity, consequently making firms more competitive and boosting a region’s economy. Not only does infrastructure in itself enhance the efficiency of production, transportation, and communication, but it also helps provide economic incentives to public and private sector participants. The accessibility and quality of infrastructure in a region help shape domestic firms’ investment decisions and determines the region’s attractiveness to foreign investors. This relationship between infrastructure development and economic growth has not gone unnoticed by the world’s two most populous countries, China and India, which have a combined population of almost 2.5 billion. The experience of these two rapidly growing nations illustrates how different the paths to growth can be.

For the most part, India has forgone the typical manufacturing export–led path to development and instead focused on its service sector. Although India has been very successful in information technology services and business-processing exports, its inadequate and dilapidated infrastructure has held back growth in the manufacturing sector.

However, this budget seems quite promising as far as the infrastructure sector is concerned. This budget has laid out a clear and tangible roadmap for the future. The roadmap includes:

• Sharp increase in outlays of roads and railways.
• Capital expenditure of public sector units to also go up.
• National Investment and Infrastructure Fund (NIIF), to be established with an annual flow of `20,000 crores to it.
• Tax free infrastructure bonds for the projects in the rail, road and irrigation sectors.
• PPP mode of infrastructure development to be revisited and revitalised.
• 5 Atal Innovation Mission (AIM) to be established in NITI to provide Innovation Promotion Platform involving academicians, and drawing upon national and international experiences to foster a culture of innovation , research and development. A sum of `150 crore will be earmarked.
• Concerns of IT industries for a more liberal system of raising global capital, incubation facilities in our Centres of Excellence, funding for seed capital and growth, and ease of Doing Business etc. would be addressed for creating hundreds of billion dollars in value.
• (SETU) Self-Employment and Talent Utilization) to be established as Techno-financial, incubation and facilitation programme to support all aspects of start-up business. `1000 crore to be set aside as initial amount in NITI.
• Ports in public sector will be encouraged, to corporatize, and become companies under the Companies Act to attract investment and leverage the huge land resources.
• An expert committee to examine the possibility and prepare a draft legislation where the need for multiple prior permission can be replaced by a pre-existing regulatory mechanism. This will facilitate India becoming an investment destination.
• 5 new Ultra Mega Power Projects, each of 4000 MW, in the Plug-and-Play mode

Where will the money for infrastructure investment come from? In many cases, current account surpluses (more exports than imports of goods, services, and transfers) will enable developing countries to increase their investment in infrastructure. Oil revenues, as well as sovereign wealth funds (state-owned financial asset accounts), are also becoming increasingly important sources of funding. And investment banks like the European Bank for Reconstruction and Development, the Asian Development Bank, and the Inter-American Development Bank are making more money available for infrastructure in developing countries, such as India

India’s achievement or potential problem : low inflation

Greetings Readers,

India recently recorded a near zero inflation in December 2014. So, in this postwe will focus on the benefits and shortcomings of such inflation and then round it off with the step taken by the Central Bank that is the RBI post such inflation.

Now for those who don’t know much about this, Inflation as we earlier mentioned is the recurrent rise in prices. India faced high inflation in food prices a few years back and post the 2008 recession the global oil prices shot up. So, we see that inflation was always potrayed as the “devil” in such cases. But then we always forget the fact that whichever country shows economic growth or progress will face positive inflation. So, inflation is not a devil but is a sign of development and progress. Though high inflation as well as low or even negative inflation have their own advantages as well as disadvantages.

Low inflation is when the annual rate of inflation is not more 3%. We have to go back to the nineteenth century to see prolonged periods of economic growth with zero (or negative inflation). In the twentieth century, people have come to expect modest inflation. Because we expect modest inflation, it tends to occur. It is rare to find positive economic growth with zero inflation.

Problems of low inflation :

• Increased real debt burden. If people expected an inflation rate of around 3-4%, they may take out debts, assuming a future inflation rate of 3-4% to help reduce the real value. However, if inflation is at 0.5%, the real value of the debt will fall much more slowly than expected. Governments will also struggle to reduce debt to GDP ratios because with low inflation, tax revenues will rise much more slowly than expected.
• Difficulty of adjusting wages and prices. This is particularly a problem for the Eurozone where fixed exchange rates mean countries like Spain rely on a prolonged period of falling prices to restore competitiveness.

Potential Benefits of low inflation :

Despite the many serious costs of low inflation. The ‘right kind of deflation’ could be beneficial.

1. Improved international competitiveness. If one country has deflation, and others have inflation, then that country will become more internationally competitive, leading to a rise in exports. During Japan’s deflation, they saw strong exports – which helped offset the fall in consumer spending (though it still wasn’t enough). However, if there is a region wide period of deflation – e.g. Europe in 2014, then you are not getting this competitive advantage.

 

Thus we that low inflation in the economy has its own pros and cons. So, in December 2014 India saw that the inflation persisting in its economy had come down to 0.11% (WPI)  and 4.4%(CPI). This showed that the RBI was achieving its goal about keeping inflation low in the country. Post this success, Raghuram Rajan, governor of RBI announced a cut in the repo rate or the repurchase rate from 8% to 7.75%. This was the first reduction in over 20 months. RBI who had in November resisted and didn’t budge to reduce the borrowing costs as requested by Narendra Modi, Prime Minister of India had reduced these rates rather surprisingly. The main reason behind this decision is the very low inflation. This was also a signal to the present BJP government that it should now move towards incurring fiscal deficits in order to reduce the cost of living by reducing the bottlenecks in the India’s infrastructure. Now we look forward to the upcoming Budget of the government following the rate cut by the RBI.

-Vishal Kataria

USA and Inflation Targeting

Greetings,

Inflation Targeting policy framework involves ‘the public announcement of inflation targets, coupled with a credible and accountable commitment on the part of government policy authorities to the achievement of these targets’.

A developing country like India undertakes inflation targeting due to high rates of inflation prevalent in the economy. Through inflation targeting the central bank annouces and then actively works towards lowering inflation using monetary policy tools like interest rates. In India the targetted rate of inflation is 8 per cent by January, 2015, and 6 per cent by January, 2016.

As of 2012, 28 central banks around the world adopted inflation targeting. US officially announced a target rate of inflation for the first time in 2012. The Fed set it at 2%. The statement from the Fed was

“Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the committee’s ability to promote maximum employment in the face of significant economic disturbances”.

This move by the Fed ensures transparency and attempts to create expectations rather than simply respond to them.  A reason for why the Fed decided to adopt this system was the threat of deflation that loomed over the American economy after the 2008 financial crisis. India needs inflation targeting due to fear of high inflation while America needs it to ensure there is no deflation.

A lower inflation rate would be associated with an elevated probability of falling into deflation, which means prices and perhaps wages, on average, are falling-a phenomenon associated with very weak economic conditions. Having at least a small level of inflation makes it less likely that the economy will experience harmful deflation if economic conditions weaken.

Before we move on-why is deflation bad? In other words, what are the  reasons for wanting inflation?

First, a healthy economy actually does better with some expectation of inflation. As prices rise, people buy more now because they want to avoid higher prices for consumer products. When shoppers expect prices to rise in the future, they are motivated to buy more now so they can get the lower price. This “buy more now” philosophy stimulates the demand needed to drive economic growth. For investments, they buy now because they are confident it will give them a higher return when they sell later. If inflation targeting is done right, prices rise just enough to encourage people to buy sooner rather than later.

Second, a little inflation is preferable to deflation, which is when prices fall. The dangers of deflation were clearly illustrated by the housing market collapse in 2006. As prices fell, homeowners lost equity and even the home itself. New potential buyers rented instead as they were afraid they would lose money on a home purchase. Everyone, including investors, waited for the housing market to recuperate. As this happened, the lack of demand just forced housing prices further into a downward spiral. Confidence in the housing market wouldn’t be restored until buyers could again expect that prices will go higher. This is equally true for any other market where deflation has taken hold. The difficulty is in creating the right economic climate to create rising prices. Inflation targeting works because it stimulates demand just enough.

In spite of the fear of deflation and its negative effects, there are concerns surrounding the inflation targeting policy. The Fed has a dual mandate to

“promote the objectives of maximum employment, stable prices, and moderate long-term interest rates”.

The consequence many people feared was that unemployment rate would spike in a bid to keep inflation at 2%. The Fed would allow for inflation but only up to a point. In 2012, US was still facing a problem of unemployment. The fear was that this problem would go unsolved.

In the long run, price stability and the other goals of monetary policy are not mutually exclusive. Economic growth is only affected by real variables in the long run.

However, short-run price stability will frequently conflict with these other goals of monetary policy. Faced with rapidly rising prices, the Fed would have to cut the money supply and raise interest rates. Doing so increases short-run unemployment and creates volatility in financial markets.

A dual mandate gives central banks the freedom to stabilize employment in the short run while still setting a long run policy target of price stability.

But again there is a flipside. If people believe that the central bank is always going to promote employment over price stability in the short run, they will revise their inflation expectations upward.

In spite of its shortcomings it has advantages for both developed and developing countries. Such clarity facilitates well-informed decision making by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society.

For developing countries, it helps them control inflation. For developed countries it prevents them from slipping into deflation.

Madhunika Iyer

Overcoming Inflation

Hello readers,

This week I will be talking about how a good monetary policy can help us overcome high rates of inflation and also other measures to overcome inflation.

Why monetary tool is most important:-

Monetary policy is not the only tool for managing aggregate demand for goods and services. Fiscal policy—taxing and spending—is another, and governments have used it extensively during the recent global crisis. (To reduce inflationary pressures the government  increases tax and reduces government spending).However, it  takes time to legislate tax and spending changes, and once such changes have become law, they are politically difficult to reverse. Also consumers may not respond in the intended way to the fiscal policy (for example, they may save rather than spend a tax cut).Therefore, it is easy to understand why monetary policy is generally viewed as the most important. Most economists think monetary policy is best conducted by a central bank that is independent of the elected government. The most common monetary policy used is to increase interest rates. If the central bank increases interest rates, for example, borrowing costs rise, consumers are less likely to buy things they would normally finance—such as houses or cars—and businesses are less likely to invest in new equipment, software, or buildings. This reduced level of economic activity would be consistent with lower inflation because lower demand usually means lower prices.

DIFFERENT WAYS IN WHICH MONETARY POLICY CAN BE IMPLEMENTED

1-Taking the right inflationary measures first requires us to identify the types and causes of inflation. If a country’s central bank is committed to ensuring price stability it can implement contractionary policies .

2-Some central banks chose to impose monetary discipline by fixing the exchange rate—tying its currency to another currency and, therefore, its monetary policy to that of the country to which it is linked. However, when inflation is driven by global rather than domestic developments, such policies may not help.

3-In some cases the government may directly set prices (as some did in 2008 to prevent high food and fuel prices from passing through). Such administrative price-setting measures usually result in the government accruing large subsidy bills to compensate producers for lost income.

Monetary policy needs to be adjusted in such a manner to the evolving growth-inflation dynamics so that we move towards our potential growth in a non-inflationary manner.

Other measures to reduce inflation:

Wage Control

Wage growth is a key factor in determining inflation. If wages increase quickly it will cause high inflation. In the 1970s, there was a brief attempt at wage controls which tried to limit wage growth. However, it was effectively dropped because it was difficult to widely enforce.

2. Supply Side Policies

Supply side policies aim to increase long term competitiveness and productivity. For example, privatization and deregulation were hoped to make firms more productive. Therefore, in the long run supply side policies can help reduce inflationary pressures. However, supply side policies work very much in the long term. They cannot be used to reduce sudden increases in the inflation rate. Invest to boost production of protein rich food, cooking oil, etc. The supply of these items currently lags behind the demand.

3-Invest in infrastructure, cold storage so that food produced is not wasted in the distribution process. Perhaps money that will tentatively come from Foreign Direct Investment in retail move can help towards this.

4-Sound Economic Policy– No better solution than this. If everything goes well with economy, inflation is bound to come down. Promote export that will help appreciate the Indian Rupee (INR) and bring down crude prices which have a major impact on inflation. Make strong laws to stop hoarding.

5-Coordination between the government and the central bank-The interest rates in India are high. There are more than a dozen consecutive rate hikes.  Consumption in India is not just tied with economic growth but also tied with public subsidies. The government runs huge subsidy bills through various ‘populist’ policies. Now there is a disparity in the activities of the central bank and the government. The central bank wants to moderate consumption while the government, by its subsidies, indirectly encourages consumption and thereby indirectly nullifying the effects of RBI. Therefore as we can see there should clearly be coordination.

6-Other measures like Direct cash transfers are also aimed at the same thing. These measures come with a lag and we have to wait and see the long term effects.

These according to me are the best measures to curb inflation. I would be very happy if you all shared your views with us.

Vedika Kedia

THE COMMITTEE DIAGNOSIS

Greetings Readers,

As we brought up the topic of Urijit Patel Committee last week we will be continuing our discussion about it by evaluating the recommendations made about by the committee. As we know the committee made three recommendations namely :

• To focus on exchange rates
• To focus on multiple parameters
• RBI should target inflation only.

So we will be scrutinizing them by highlighting both the pros as well as the cons of those aforementioned recommendations.

FIRST RECOMMENDATION: FOCUSING ON EXCHANGE RATES.

PROS

If the RBI focuses on the exchange rates the biggest gainers are the exporters and importers who now can decide their business expansion plans accurately. By this they will also be able to keep the prices of imported goods under check especially that of crude oil. Thus, indirectly keeping a check on inflation.

CONS

This method of focusing on the exchange rate may well be effective in controlling fuel inflation but is a bad measure for controlling the food inflation (Domestic). Moreover this strategy will make the exchange rate vulnerable to speculative shocks and which will be harder to control as it won’t be possible to charge the foreign investors under the FERA/FEMA laws as they lie outside the jurisdiction.

This policy works well for the small countries like Singapore, Taiwan, etc and not like countries the size of India or Brazil as these nations have a large population and cannot sustain on imports of food and thus must be self reliant in the production of food.

Lastly, this strategy of targeting the exchange rate is outdated and was majorly used during the WW1 period and henceforth the central banks of developed nations have shifted to inflation targeting strategies.

SECOND RECOMMENDATION : FOCUS ON MULTIPLE PARAMETERS

CONS

The major flaw in this recommendation is that it doesn’t have an actual target or like we say a nominal anchor. So, it is ineffective.

With RBI focusing on WPI instead of CPI, the main drawback is that WPI doesn’t account the inflation related changes in the service sector. And as the service sector contributes more than 60% to the GDP, so when the monetary policy is designed, it fails to consider the service sector inflation and thus, becomes ineffective.

THIRD RECOMMENDATION : FOCUS ON INFLATION

PROS

The central banks in all the advanced and emerging economies have adopted this method as it brings transparency and it makes it easier to track progress as the CPI data is released every twelve days. Thus, if the RBI decides to set a CPI target, no informal pressure can be put by various groups and even the common man can monitor and track the effectiveness of the policies of the RBI.

So to conclude, the committee has recommended that the RBI should focus on the exchange rate as most importantly inflation by switching on to CPI for its calculations. Whereas, it should stop its focus on multiple indicators such as WPI, etc as it has proved to be ineffective.

So, now that we have scrutinized these recommendations, what do you think is or should be done to tackle this existing problem of inflation?

Thank you for the patient reading!!

– Vishal Kataria

 

What keeps it going!

Hello readers,

Like mentioned last week, this week’s post will focus mainly on the Urjt Patel Committee Report and what are its recommendations. So, lets start with the basics of the report. The committee report was formed by RBI  (and not finance ministry). It’s official name is ‘Expert Committee to Revise and Strengthen the Monetary Policy Framework’ and its chairman is Dr. Urjit Patel, Dy. Governor of RBI.

This committee report consists of certain recommendations and I’ll be concentrating on those recommendations over the course of this article.

There are three main ways to frame monetary policy( the recommendations) according to the Urjit Patel Committee

1. Focus on Exchange Rate
2. Focus Multiple indicator (GDP, IIP, Exchange rate, inflation)
3. Focus on inflation

what will happen if we focus o the first recommendation, that is, to focus on exchange rates.

• If RBI adopts this strategy/method to frame monetary policy then- what will happen?
• Rajan will first decide an ideal “target” exchange rate say 1$=Rs.50.
• Then he’ll try to amend monetary policy to control rupee supply in the market.

To put this in technically incorrect example: Imagine dollars are “apples”.

• Prices of apple vs Rupee are decided by laws of supply and demand.
• At present 1 apple sells for Rs.60. But Rajan wants to bring it 1 Apple=50 rupees. What should he do?

1. Rajan will tweak his monetary policy to reduce the supply of rupee in the market. Then, 1 apple will sell for Rs.50. (apple supply is same but rupee supply is decreased.)
2. Alternatively, Rajan will open his own refrigerator (forex reserve), and put some apples (dollars) for sale. That’ll also bring down prices of 1 apple =50 rupees. (because apple supply increased)

what will happen if we focus o the second recommendation, that is, focus on multiple indicators.

Under multiple indicator method, Rajan will first gather information about:

1. Index of industrial production (IIP), Consumer confidence
2. Professional forecasts (CRISIL, S&P, Moody, World Bank) about GDP, inflation, unemployment
3. Inflation data: WPI minus food, fuel.

Then, he will design the monetary policy (mainly repo rate), with following objectives/focuses:

1. Increase employment
2. Increase GDP
3. Stabilize inflation
4. Stabilize exchange rate

And then finally,

The third recommendation being that RBI must target inflation only. Nothing else- don’t focus on increasing employment, don’t focus on increasing growth, don’t focus on stabilizing rupee-dollar exchange rate. Just focus on one thing  and one thing only- Inflation. In this strategy- Rajan will decide a “Nominal Anchor” say CPI -to monitor inflation. Then he’ll fix an inflation-target say 2-6% and adjust his monetary policy so that inflation remains within that range.

this post mainly dealt with the basic features under the three recommendations that were proposed under this committee meeting. Next week we will post about the effects, both negative and positive, of these recommendations proposed.

happy reading!

-Saguna Datt

ONIONS FORCE A PATH

India’s monetary policy is set for a radical overhaul. That was the headline in a leading financial newspaper at the start of the year. Dr. Raghuram Rajan assumed office as the Governor of the RBI on 23^rd September, 2013. One of his first acts as Governor was to appoint the Urjit Patel Committee to reform the approach to frame monetary policy. The obvious question is-why? But first let us understand why inflation is a major issue for India.

 

Inflation: a major issue for India

 

All countries experience business cycles and have periods of boom and recession. Every economy has a certain rate of inflation. Infact 2-3% inflation is considered to be beneficial for the economy. A high rate of inflation becomes dangerous for an economy during times of recession. Why is a combination of inflation and recession, or ‘stagflation’, dangerous? When an economy is in a period of recession, demand is low, investment is low, there is unemployment as jobs are not created. Inflation during such times has a massive adverse impact on the economy and especially the low income group.

 

This is where it becomes relevant for India. Ever since the 2008 financial crisis, the ensuing recession, and the high rate of inflation (India has the highest inflation rate compared to any other developing country) have been a major challenge for the central bank. Food inflation is the main reason for the persistently inflation in India. Food inflation in India stood at 14.72% in November 2013. As per Business Standard, food inflation in India averaged over 12% (annualized rate per month) over the last 60 months between 2008 and 2013. That’s a five-year long period!

 

 

Since inflation is a pressing issue and it is relevant to think about how monetary policy is used to control inflation. Until the Urjit Patel Committee Report which was relased in January 2014 the Reserve Bank of India framed the monetary policy in such a way that it focused on multiple indicators.

The image below sums up the various ways to frame monetary policies.

 

Using monetary policy as a tool to focus on exchange rates is pertinent for a country which is heavily dependant on exports. Since our focus is on india we will look at the multiple indicators approach and try and understand why the RBI felt the need to dispense with this approach.

 

As of 2013 multiple indiactors approach was used by the RBI. What does this approach entail? The RBI gathers informtion on GDP, inflation and unemployment forecasts made by professional agencies. Accordingly the monetary policy is framed witht the aim to increase GDP, increase employment, stabilise inflation.

 

Has this approach worked? What are the problems with it?

 

Emperical evidence shows that this approach works in periods of high grwoth but this approach has inherent problems which stop it from being effective in periods of low growth. When the economy is in a depression absence of a publicly known/declared target ( for eg: 5% inflation) puts considerable pressure on the central bank to deal with competing interests of various groups. For example, an exporter would want the monetary policy to be framed in a way where 1$ = Rs 60 while an importer would want 1$ = Rs 30. Also, the government would want the SLR and CRR rates to be high so that banks would have to purchase more governemnt securities and thereby increase governemnt revenue. On the other hand, banks would want low CRR and SLR so that they can lend more.

 

As is evident from the above example, having to consider a lot of parameters, with discretion to decide on outcome could lead the economy to less than optimum result. You could achieve a little of everything but it will not be most optimum result for the economy.

 

So far we have seen the drawback and therefore the need to change the multiple indicators approach to the formulation of monetary policy. Next week we will dwell on the Urjit Patel Committee Report and the method suggested in the report.

 

 

-Madhunika Iyer

 

Please do post your comments, opinions and any aspects related to our topic that you want us to explore in subsequent blog entries/posts.