In its policy review on May 3, the Reserve Bank of India (RBI) did bring down the repo rate by 25 basis points but it also presented a gloomy outlook on growth and inflation which left the stock markets cold. The Sensex, which had surged in anticipation, fell 160 points. What makes the RBI so negative when even rating agencies are inclined to accept the emergence of green shoots?

RBI Governor Duvvuri Subbarao has himself spelled out the risks. “Upside risks are still significant in view of sectoral demand supply imbalances, the ongoing correction in administered prices and pressures stemming from increases in minimum support prices,” he said. Is Subbarao’s risk assessment genuine or has it been exaggerated to put the government under pressure?

Sectoral imbalances may take time to fully correct but if as anticipated by the India Meteorological Department the monsoon this year is normal, the supply deficit will be considerably reduced. It is quite likely the correction in administered prices may also be downwards rather than upwards with international commodity prices, including that of crude oil, moving south.

But there is certainly the risk of an increase in minimum support price, which has been the cause of inflation creeping upwards. The increase in food grain support prices each year has become a source of inflation with the potential to spread throughout the economy. First, there is the direct effect. A 5 percent increase in prices can lead to inflation going up by 0.75 percent. Second, there is the derived effect. The increase in support prices is reflected in the cost of living and consequently wages, raising the cost of manufacture to push up inflation by 1.3 percent. The direct and indirect effect of a 5 percent increase in support prices adds 2 percent to inflation. This is a genuine risk but not too significant.

Surely there are risks of inflationary pressures but these have apparently been exaggerated by an RBI possibly expecting the government, which is keen on interest rate reduction, to take supplementary measures. Even so, the RBI monetary policy need not have been unduly restrictive and the outlook unjustifiably gloomy.

What is critical is inflation should not be the single policy target. Growth and employment are other objectives and to accommodate these, the repo rate should not be in excess of the inflation rate. After all, the repo rate is addressed to commercial banks. The rates charged by the latter to the borrowing public are in excess of the repo rate by at least 200 basis points.

No wonder many central banks, including the European Central Bank, no longer go by inflation alone but mould their policies to stimulate growth and employment. Hence, their repo rates are close to or even less than the inflation rates. The RBI has been too conservative and as a result, the country has lost growth and employment without keeping inflation within a tolerable limit.

For nearly three years now, the Reserve Bank of India (RBI) monetary policy has had a single target. The presumption is that only when inflation is below the tolerance limit can the interest rate be made normal.

The last time the repo rate was reduced was on March 19 when it was cut by 0.25 percent, a change understandably ignored by commercial banks and other financial institutions. With the repo rate at 7.5 percent and inflation down to 5.9 percent, the market expects the RBI to cut the repo rate further at its next policy review on May 3.

At 7.5 percent, the repo rate is still too high to rev up GDP growth. Interest eats into the profitability of companies and reduces their rate of return. This directly hits stock prices and makes it difficult for companies to raise equity capital that is critical to fund investment. High interest rates significantly increase EMIs on home loans and affects demand for other durable consumer goods such as cars which are bought on credit. No wonder growth in industrial production dropped to less than a percent in 2012-13.

The RBI’s monetary policy seems to be influenced by two considerations. The interest rate has to be above the rate of inflation and there should a minimum margin between the repo rate and the rate of inflation. That is not how other central banks are managing their money.

In a sample of 10 countries, only half had their central bank lending rates above the rate of inflation. These were China, India, Japan, Russia and South Korea – with the average central bank rate at 4.9 percent and average inflation at 3.1 percent. That accounts for a margin of 1.8 percent between interest rate and inflation. Five others – the euro zone, Indonesia, Turkey, the UK and the U.S. – ignored inflation altogether. In this case, average inflation was at 3.8 percent while the average central bank lending rate was 2.1 percent.

Central banks in most countries, even the European Central Bank, did not aim for a single-digit inflation target. In adverse economic conditions, growth and employment matter more and the rate policy makes inflation almost secondary. Taking all the sample countries together, the average inflation rate and the average lending rate of central banks were nearly equal.

The experience of the past three years of inflation in India has made it amply clear that a high rate of interest does not check inflation but certainly checks growth and employment. That is too much of a price to be paid for the conservatism of our central bank. The RBI annual review in May offers an excellent opportunity to look at other policy objectives which have been deliberately overlooked and engineer successive cuts in the repo rate to bring it in line with inflation before the year ends.

Since November, the price of gold has been unstable but in April, its decline was precipitated. What is surprising is not the fall itself but its speed. In just two sessions, gold prices dropped 13 percent in the steepest fall in 33 years. It wasn’t gold alone that got caught in the bear grip. Prices of other commodities such as silver, crude oil, copper and so on also declined, but not as sharply.

Why? Simply because the factors that caused commodity prices to rise in the last five years were no longer relevant. Gold was selling at $625 an ounce (860 rupees per gram) only six years back in 2008. That October, the world was plunged into a financial crisis of an unusual magnitude. Since then, there has been a rush for gold as an investment. Stock markets crashed, interest rates plunged, investors lost faith in financial assets and opted for gold as a safe investment.

That presumption was supported by subsequent trends in gold prices. Over the next five years, prices shot up in India as much as 3-1/2 times, making gold not only safe but also the most lucrative investment. The stock market took all that time to recover from the 2008 shock but has not, even now, come up to pre-crisis levels. Gold became a preferred part of the portfolio and gold-backed exchange traded funds (ETFs) were a favourite with investors.

The financial crisis had engulfed the world economy. Some countries such as the United States, Japan and the UK went into short recessions. Most emerging market economies had to slow their pace of growth. In this context, gold became a hedge against economic adversity. These conditions have now changed and caused gold prices to fall.

Dow Jones is back in the hands of the bulls, home prices in the U.S. have been rising, the Federal Reserve will reduce asset purchases which were used to pump in money, and the dollar has gained against the euro and yen. As a result, confidence in the financial markets has returned, making alternatives to investment in gold more attractive.

The trigger for the collapse of gold prices on April 13 was mainly the decision of the Cyprus government to raise money by selling gold valued at $523 million. That was supported by the European Central Bank which even encouraged other countries in Europe facing sovereign debt problems to do likewise, creating the scare that the market for gold will be flooded. The price of gold dropped in anticipation. Many investors trimmed their positions in ETFs but not retail investors.

The fall in the price of gold is a market adjustment influenced by greater confidence and better yields in other assets. Possibly, there may not be further price correction in the current year except for short periods. But a sharp increase in prices is equally unlikely. That does not make gold a good investment for the present.

The food security bill will be introduced in the current budget session of parliament, more because of its populist appeal than any economic urgency. Even when the bill was discussed by the Cabinet, Finance Minister P. Chidambaram and Agriculture Minister Sharad Pawar reportedly had reservations. They had valid reasons.

Subsidized food distribution is nothing new. Already 400 million people avail of it from over 500,000 fair price shops. What the bill intends is to widen the scope of the present scheme and cover two-thirds of the population with five kg of grain per beneficiary at nominal rates.

The finance minister has provided for 900 billion rupees as food subsidy in Budget 2013. That’s about 40 percent of the total subsidies and 2 percent of India’s GDP. Under the food security bill, the subsidy for the full year would be 1.2 trillion rupees, which will take the budget deficit to 4.85 percent from 4.8 percent.

C. Rangarajan, chairman of the Prime Minister’s Economic Advisory Council has suggested that if total subsidies are contained at 1.2 percent of the GDP, there should not be any budgetary problem. That means that if subsidies on food have to increase, subsidies on other products, such as petroleum, will have to be lowered or withdrawn. Whether this financial balancing is politically feasible is anybody’s guess.

The question is not only of budget distortion that food security can cause. Equally important is whether there will be enough food grain to go around. Presently, the government procures about 40 million tonnes of cereals. With the need to distribute additional food grains to a larger section of consumers under food security, the government will have to procure an additional 35 million tonnes. That will instantly reduce the amount of grain sold in the open market, creating scarcity and inflation.

Farmers are worried that the government will emerge as the single major buyer of food grains and will regulate the margin between procurement price which farmers get and the issue price which consumers have to pay. Since the latter is nearly fixed, procurement prices may not be allowed to increase. That is what farmers fear.

It is tempting to look upon the food security bill as an election gimmick like the loan waiver scheme adopted five years ago. But food security is also an excellent political instrument to accelerate economic growth. That is the experience of most countries. Food security enables a better diet for all people and enhances labour productivity which is critical for higher GDP growth.

But to eliminate the possible adverse consequences and make food security economically efficient, it is necessary that agricultural production is simultaneously increased and petroleum subsidies substantially reduced. With that, the additional procurement will not result in market shortages and inflation and total subsidies will not exceed 1.2 percent of India’s GDP.

The Supreme Court verdict on Glivec brought to an end the battle by Swiss drugmaker Novartis to exclusively market the cancer medicine. In doing so, the bench enunciated a principle to justify a patent only by its intrinsic worth of innovation.

The exclusive marketing right for Glivec was granted in 2003 for a period of five years. Once a drug is off-patent, the product/process can be freely copied. But many companies try to extend the life of the patent further by making marginal changes which are not relevant to the product’s effectiveness. To what extent these devious changes amount to innovation becomes a matter of judgment.

The Supreme Court verdict focuses on this issue. It is certainly not against protection to innovation. But insignificant changes to a product which do not enhance its therapeutic efficacy do not make it a new invention. There is no ‘novelty’ in the change, the court said, and no new substances are used in the drug.

Intellectual property rights are fundamental to innovation. Protection is necessary to recover the cost and make profits. Surely, the cost can be quite high. In the pharmaceutical industry, it is estimated that a genuinely new drug costs over $1 billion for research and clinical tests. But the major unaccounted cost is the cost of failure. That can push up the overall cost of research quite substantially, possibly three to four times.

Research is the key to business leadership. The top 20 pharma companies spend, on average, over $4 billion a year and the very large ones – such as Novartis, Roche and Pfizer – more than $6 billion a year. When they innovate a drug, the money spent on research has to be recovered, for which countries recognise and grant protection under the Patents Act. Initially the drug remains costly; once the tenure of the patent is over, the drug price drops to the cost of production and marketing.

Drugs which are still under patent protection are relatively few, possibly about 10 percent of the pharma market. The bulk market is for generics in which India is progressing rapidly and tops the world market with exports exceeding a fifth of the world’s total. The major markets are the United States, Russia and South Africa. Even developed countries are moving towards unbranded generics to reduce the cost of health care.

The pharma industry in India is growing at more than 15 percent per year. With foreign direct investment now permitted up to 100 percent equity and the spate of mergers and acquisitions, the share of MNCs in the pharma industry has substantially increased.

India is going to be an excellent hub for the pharma industry as a destination for phase III clinical trials. The industry should now invest more in research using protection under the patents law, which is in tune with the TRIPS Agreement since 2005.

Finance Minister P. Chidambaram tried to humour the market in his budget by cutting the Securities Transaction Tax (STT) which had been one of its sore points. But the market was not amused. The Sensex continued to slide, indifferent to the budget which was presented with a lot of expectations.

This appears to be rather strange because the budget was well received by the industry, in spite of the increase in surcharge from 5 to 10 percent. It was possibly the realization that the finance minister lived up to his promise of cutting fiscal deficit to 4.8 percent which created an infectious confidence in growth revival.

Chidambaram could have hardly done anything more, considering there were economic and political compulsions he could not ignore. No big bang was possible and no big tax mobilization was undertaken.

The reduction in fiscal deficit was a good reason for the market to have responded positively to the budget. Because it would start a chain of events that could see the industry recover from a stalemate. First, the additional borrowing by the government in 2013/14 would be small and would not crowd out the financial market. Second, the Reserve Bank of India (RBI) has been harping on a reduction in fiscal deficit as a precursor to cut interest rates.

Before the budget, the market had been under bearish pressure. After climbing to 20,103 on Jan. 25, the Sensex had gradually dropped 4.2 percent by Feb. 27 and further by 1.3 percent on budget day. The market was affected more by the negative features of the budget, including the survival of the General Anti-Avoidance Rules and retrospective taxation.

But the market recovered after March 4. Neither the fall, nor the recovery was entirely due to domestic factors. The market had been under the shadow of global factors even before the budget. The recovery was also partly due to an upsurge in world bourses. Dow Jones, for instance, touched 14,354 and crossed its earlier peak in October 2007.

There is a good chance the Sensex will bounce back. The expected cut in the repo rate can be a good trigger though part of it is already built into the recovery so far. If the RBI goes in for a 50 bps cut, the recovery will be strong.

The medium-term trend, however, will depend much on the current account deficit which is showing every sign of bloating. That may slow down FII investment which has also reached a ceiling in many companies. It does seem that the market will take some time to cross its earlier peak.

Finance Minister P. Chidambaram has apparently done the impossible. He has brought down the fiscal deficit in the current year from the budgeted 5.3 percent to 5.2 percent in spite of the fall in revenues. What’s more, the deficit was further slashed to 4.8 percent in the 2013/14 budget. Is that realistic?

Look at the expenditure. In the current year, subsidies on food, petroleum products and fertilizer were up by 676 billion rupees or 36 percent. These are precisely the expenditures the minister had to curtail, though he did make an effort to do that too late in the day. With the jump in non-Plan expenditure, the fiscal deficit could be brought down only by cutting Plan expenditure.

Budget 2013 is designed to rev up economic growth by correcting expenditure imbalance. Chidambaram has proudly declared that Plan expenditure will be up next year by 29 percent from the revised estimate. Non-Plan expenditure also increases, though at a lower rate of 10 percent.

Subsidies have also been targeted in the budget. Total subsidies will be down by 266 billion rupees or 10 percent. The sharpest subsidy cut (319 billion rupees) will be on petroleum products. The finance minister has also provided an additional subsidy of 100 billion rupees on food but may have to shell out much more if the Food Security Bill is passed in the budget session.

To cover the additional expenditure, Chidambaram has gone in for a surcharge on personal incomes in excess of 10 million rupees and on companies with profits more than 100 million rupees. These will yield additional revenues of 180 billion rupees.

The exchequer would also gain from growth in GDP. Gains in gross tax revenues are projected at 17.4 percent with GDP presumably increasing in 2013/14 at 13.4 percent. That assumes a multiple of 1.3.

The budget arithmetic is thus based on two critical parameters. First, that subsidies on petroleum products will be drastically cut though past experience does not support that assumption. A substantial increase in diesel prices may not be possible in an election year. Also, the government is bound to be more generous in respect of food subsidies if the Food Security Bill is passed. The budget is very much exposed to this political risk.

Second, even if the economy grows at 13.4 percent in 2013/14 as assumed, gross tax revenues may not increase at a multiple of 1.3. Last year, the GDP increased 13.3 percent but tax revenues, excluding additional taxation, increased 12.1 percent. Projected tax revenues may not be realized as in the current year. That is the economic risk implicit in the budget.

On the face of it, the budget looks quite elegant. But it is subject to implicit political and economic risks, which may make it difficult to bring the fiscal deficit down to 4.8 percent.

It’s going to be a tight budget this year and Finance Minister P. Chidambaram will be looking to save every rupee in revenue to reduce the budget deficit, to which he has committed. One option would be to withdraw tax incentives which have outlived their purpose.

The finance ministry is only too aware of revenue lost from tax incentives. In 2011/12, it was a loss of 5.29 trillion rupees. If tax incentives are withdrawn, the 2013/14 budget would be in surplus. Nothing would amuse the finance minister more.

What really are these incentives? For the ministry, it is the revenue loss caused by the difference between the generally prescribed rates and effective rates of taxation. That exaggerates and even distorts the meaning of incentives.

The loss from taxation of corporates, firms and individuals is estimated at 936 billion rupees. That includes “accelerated depreciation” leading to a loss of 364 billion rupees. In the United States and many other countries, this is an accepted accounting principle.

There is revenue loss of 148 billion rupees from the corporate sector for incentives such as infrastructure development and scientific research. What needs to be identified is whether these incentives have really been effective, and if not, they need to be changed and the ones no longer necessary should be withdrawn.

There was revenue loss of 284 billion rupees from individual tax payers from savings incentives under section 80C of the Income Tax Act. The intention behind some of these concessions is not really to encourage savings but to divert those savings to the government kitty. The price is too heavy. The government and public sector units can certainly borrow from the market and pay the market rate of interest.

But the major loss of revenue is from excise and customs — 4.35 trillion rupees. The loss in excise is the difference between tariff rates and effective rates and the exemptions are in respect of areas and commodities. The loss in area-based exemptions (Northeast states, Uttaranchal, Himachal Pradesh, Jammu and Kashmir and the Kutch district of Gujarat) was 128 billion rupees while commodities accounted for 1.99 trillion rupees. The latter was mainly a device to counter inflation.

The government has powers to exempt under section 25(1) of the Customs Act to prescribe duty rates lower than tariff rates. That results in loss of revenue of 2.42 trillion rupees. The bulk of the loss has been in respect of imports of crude oil and edible oils and was deliberately incurred to lower costs.

Surely exemptions and incentives have specific objectives such as promoting exports, defusing inflation or benefiting backward areas. The question is — should we tamper with the tax system and the benefits arising from grants and subsidies? In any case, the government needs to review tax exemptions and incentives, and identify those that have outlived their purpose.

Finance Minister P. Chidambaram is only too aware of the damage done by the last budget and has to an extent repaired it to unleash investment. The next budget should confirm his commitment to growth.

The budget is an important tool which, if used properly, can fuel the economy. September onwards, the government has announced measures to turn the economy around and the next budget can be designed to give the big push that is needed.

Surely, there are limitations. GDP growth is down to 5.3 percent and of industry, even lower. This will slow down the generation of tax revenues. To keep the fiscal deficit within 4.8 percent of GDP, as promised by the finance minister, will need a restraint on expenditure.

With fiscal deficit at 4.8 percent, government borrowing cannot be more than 5 trillion rupees, with GDP at current prices at 105 trillion rupees. Any increase in expenditure will have to come from revenue receipts, mainly taxation.

Chidambaram is unlikely to change income tax rates which have stabilized over time. There is surely pressure to tax the very rich following the U.S. initiative. A better option is to mop up revenue by taxing conspicuous consumption. That will not hurt foreign investment. Either way, a substantial increase in revenue cannot be expected.

The other option is to adjust incentives and concessions which bring down the effective rate of taxation. But at this time, when there is a need to rev up investment such a step would be unwise.

It is really indirect taxation that has greater potential, more so the Goods and Services Tax (GST). But looking at differences among the states and the centre and the lengthy procedures that will have to be followed, GST will not be implemented before 2015.

Government revenues have been increasing at 12.4 percent, which can take them to 10 trillion rupees in 2013-14. With government borrowings limited to 5 trillion rupees and loan recoveries at a little more than a trillion rupees, the government can, at best, spend 16 trillion rupees next year. This would be higher than this year’s budgeted expenditure by only 7.2 percent.

Currently, expenditure growth is 14 percent. So the real challenge in the next budget will be to control spending.

Some spending, such as interest payments and defence, which amounts to about a third of total expenditure, cannot be reduced. But there are others, principally subsidies, which can be.  Already, the price of diesel has been increased, railway fares have been raised and a cash transfer scheme introduced. This indicates the government’s determination to take unpleasant but economically necessary decisions to reduce the fiscal imbalance. But these measures do not amount to a solution and further steps will be needed to trim expenditure.

Even though Budget 2013 is likely to be the last before the elections, Chidambaram has assured that it would “not be populist but responsible”. And the emphasis could be on growth to generate jobs and revenues.

The current account deficit (CAD) which touched 5.4 percent of the GDP is a matter of deep concern. It is well beyond the 3 percent danger mark which was crossed more than 18 months back and caused the rupee to depreciate.

The only solution that the government has been pondering over is to cut import of gold. True, in spite of being one of the poorest nations we have the world’s highest stock of gold.   The appetite for gold has increased recently because gold has been the only asset to earn high returns. This is so in the rest of the world as well, because of the uncertainty created by fears about recession in EU and the U.S. Therefore, it would be difficult to curb import of gold.

Gold was not however the main cause for the escalation in CAD. In the quarter ending September when CAD climbed to 5.4 percent the share of gold in total imports was actually down from 11.6 percent to 8.6 percent. It is the collapse of  goods exports that inflated the trade deficit which could not be made up by exports of services or remittances from Indians resident abroad.

Exports were doing pretty well until March 2012. Inflation did erode the competitiveness of exports; but it was substantially made up by the weaker rupee. Cotton exports were curbed because of political pressure; exports of iron ore from some of the mines were stopped by a Supreme Court Order. Exports of petroleum products slowed down as also of diamonds and other precious stones. The main cause is attributed to recession in developed countries.

That is not quite reflected in the direction of exports. Surprisingly our exports to North America have not dropped but actually increased. So also our exports to West Asia. We have surely been losing in Europe, which is already in recession, and also in ASEAN and China which are progressive economies. These conflicting trends in exports of different products or to different markets need to be understood to take steps to restore export dynamism.

It is true that import of some of the goods, if not gold, helped bloat up the trade deficit. Import of mineral fuels increased because of heavily subsidised consumption, more particularly, of diesel.  Naturally, the share of mineral fuels in total imports rose from 35.3 percent to 37.9 percent.

In spite of the sharp increase in CAD foreign exchange reserves remained more or less in tact because of the financial support from FII and FDI. These sources are not, however, dependable in an environment of uncertainty. It is therefore important to check CAD and for that reason prevent trade deficit from escalating.

There is more to collapse of exports than recession in EU and Japan. Other countries like China or South Korea have been able to win back markets. There is no reason why we cannot. What is necessary is to invest in market development and ease the routes for exports to take place.