Critical steps for a faster recovery

December 11, 2011

(The views expressed in this column are the author’s own and do not represent those of Reuters)

The economy seems to be heading for a hard landing. The problem is not entirely of our making; partly it is the spillover of the crisis in Europe. Other Asian countries have also been affected but we were hit the hardest.

Surely, the economy was exposed to inflation for nearly 25 months now. The RBI initiated conventional measures. The repo rate was raised in 13 instalments from 4.75 to 8.5 pct. It made no change to inflation. The high cost of credit only inhibited investment. New investment, for instance, dropped from 6 trillion rupees per quarter to 3 trillion rupees.

Inflation was initially confined to select food articles. The increased expenditure on food diluted demand for manufactures and slowed down industrial growth. Further, food inflation increased wages and salaries since these are linked to cost of living, spreading inflation to all sectors.

The stock market was hit initially by the European crisis. Investors lost appetite for risk and the scramble for liquidity led FIIs to disinvest. Stock prices tanked and with the increase in demand for dollars depreciated the rupee.

These trends drastically distorted corporate finances. The fall of the rupee which increased external debt servicing and the hike in domestic interest rates took a big bite of profitability. In the July-September quarter, the margin was the lowest in the past seven years.

The problems are many. Inflation is high, stock market is down, interest rates are excessive, investment has dropped, trade deficit is too large, the rupee is low, and industrial production is nearly static. The only silver lining is a 3 pct increase in agricultural production. With these inputs, GDP growth in 2011-12 will be less than 7 pct.

What needs to be done to change the course of the economy?

We cannot do anything about the Europe factor and have to live with the uncertainty for some more time. Consequently, the recovery of the stock market and of the rupee will be delayed. Hence, strong domestic fiscal and monetary measures are vital.

Inflation may be down beginning 2012 mainly due to the base effect. But it would be necessary to reduce the demand-supply gap which has emerged in respect of milk, vegetables and fruits, meat and eggs, and edible oils which have been the targets of inflation. With liberal credit and infrastructure facilities for expansion of capacity in milk processing, animal and poultry farming, supplies can be increased to bridge the inflation gap.

Vegetable production can be efficiently organised with better seeds, better methods of cultivation and better management. This can be facilitated with closer nexus between companies (in retail) and the farmers. Further, the Agricultural Produce Marketing Act needs to be amended to enlarge the market for farmers.

The repo rate has to recede on the first plausible signal of inflation reduction. It should be possible to bring down the repo rate by about 2 bps in the first quarter of 2012. This would give fillip to investment and, to some extent, the stock market as well. Economic reforms for which bills are to be introduced in parliament, if passed, should further energise industrial recovery.

It is critical that the fiscal deficit is not exceeded though the finance minister is seeking more money for higher subsidies. That would negate any reduction in repo rate and deprive the private sector of the resources for investment.

2012 can see the economy get back into a higher orbit if the government acts fast enough to initiate the critical measures that are needed.

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