The Economist on India's economy

Jun 7th 2007
From The Economist print edition

India's monetary policy is still too loose

AMERICA was the original “Goldilocks economy” (neither too hot nor too cold), but the fair maiden has now moved to India. The bears there prefer curry to porridge, but once again Goldilocks is reported to judge the economy “just right”, with strong growth and falling inflation. Indeed, concerns earlier this year about overheating are fading. Wholesale-price inflation has dropped from 6.7% to 5.1%, even as India's GDP jumped by 9.4% in the fiscal year ending in March—its second-fastest growth on record. Palaniappan Chidambaram, the elated finance minister, says it is time to shed any scepticism about the sustainability of India's strong growth. The Economist remains unconvinced.

India has much to cheer about. The economic reforms of the 1990s and stronger investment have lifted its sustainable rate of growth. But demand has also been inflated by an unduly lax monetary policy. The government thinks its target of 9% average annual growth in the next five years can be achieved without pushing inflation up. But India displays more symptoms of overheating than China does: inflation is much higher, bank lending is growing almost twice as fast, and Indian share prices have risen by twice as much in dollar terms as China's since the end of 2002. The government, initially slow to react to higher prices, has cracked down this year with a series of administrative and fiscal measures, notably banning wheat exports and lowering fuel taxes; and the Reserve Bank of India (RBI) has tightened monetary policy.

Many local economists think there has now been enough tightening. Yet the idea that Indian inflation is tamed seems to be based on five common myths. The first is that the run-up in inflation could largely be attributed to higher food prices caused by “supply shocks” in the agriculture industry; so monetary policy does not need to be tightened. In fact, manufactured goods have accounted for much more of the rise in inflation over the past year. The main reason for higher prices is that aggregate demand is growing faster than supply.

A second misconception is that the government's various schemes this year, like the wheat-export ban, have done a better job in reducing inflation than monetary policy would do. But such measures merely suppress the symptoms; they do not tackle the underlying problem. Inflation can be genuinely reduced only by a period of slower growth. And although the various schemes have helped to reduce wholesale-price inflation, the measure that the government likes to focus on, consumer-price inflation, the choice of all other central banks, is still running at almost 8% (taking a crude average of the rates for industrial, non-manual and agricultural workers).

A third myth is that the increase in fixed capital spending from 23% of GDP in 2001 to 29.5% last year will immediately lift the economy's speed limit. In the long term investment will indeed add to productive capacity, but in the short term higher capital spending boosts demand and adds to overheating.

The fourth fairy tale is based on the idea that the interest-rate rises over the past year must eventually have more of an effect—and thus slow the economy in the coming months. Interest-rate hikes certainly take time to work. The snag is that in India rates have risen by less than the increase in consumer-price inflation, and monetary conditions are still too loose. India has by far the lowest real interest rates among the world's big economies. The RBI, constrained by politicians, has been too timid in cooling domestic demand. Its attempts, until recently, to hold down the rupee through heavy foreign-exchange intervention forced it to run an overly lax monetary policy. The good news is that the RBI is now allowing the rupee to rise (see article), which should make it easier to fight inflation—if the government allows it to do that.

Lastly some critics of the central bank say that proper monetary tightening would kill the expansion. In fact, expansion is far more likely to end prematurely if inflation gets out of control and imbalances widen, raising the risk of a hard landing. Controlling inflation is the best way to sustain growth.

The bear necessities

In the longer run India's ability to grow faster depends on it unblocking its infamous infrastructure bottlenecks, notably its lousy roads, ports and power. The increase in electricity capacity over the past five years was only 57% of its targeted level, so power cuts have worsened. Skills shortages will be eased only by improving education and reforming India's rigid labour laws. This will all take time. Meanwhile, India will have to accept slower growth to keep inflation in check.