Part 1: 'This inflation is like 70s' oil shock'

In the second and concluding part of an interview, Arvind Virmani, chief economic adviser, Ministry of Finance, tells Siddharth Zarabi and Rituparna Bhuyan that the monetary policy has to be directed more strongly towards tackling inflation. Excerpts:

Do you think there is a trade-off between growth and inflation?

Traditionally, the Indian political system does not tolerate inflation above a certain level. We have crossed that point. Therefore, monetary instruments have to be directed more strongly at the inflation issue.

Does that mean we accept whatever happens on the output side? The answer is both yes and no. No in the sense that we can use one more instrument, which was dormant in the past, and that is reforms.

We are moving towards a revised wholesale price index. What is your view?

Even more important than that is the consumer price index. We need an aggregate CPI for the very reasons that I told you. The gap between the United States' CPI and the PPI (purchasing power index) is huge now. It may not be as large in India but I am sure there is a gap.

The only way we will be able to prove it is by looking at what we introduced in the previous economic survey - the private consumption price deflator. I expect that it will be much lower. My rough guess will be about 50 per cent higher than last year.

It was close to 4 per cent last year, so it may be 6 or 7 per cent this year. The implication of what I am saying about the PPI is that please do not look only at the WPI when talking about inflation or forming expectations on inflation.

Do you think the investment growth we have seen will be maintained?

The last year's preliminary estimate of gross domestic investment is about 38.5 per cent of GDP. In the last five years, GDP growth, as measured by market prices, averaged 8.9 per cent. Lots of people mention 8 per cent, or 8.2 per cent, which is not true.

One of the important drivers of this has been investment. The rate of growth of investment in real terms has jumped from roughly 9 per cent to about 18 per cent in the previous 10 years or so. In the last five years, investment has been growing at 18 per cent.

Much of this has been private investment and linked to corporate investment. Some people make this wrong judgement that because corporate profits are slowing, their (corporations') investments will slow, investment (overall) will slow, and growth will slow. The first three are correct, but the fourth is not.

The rate of investment, that is, investment divided by GDP, has reached 38.5 per cent. This happened because investments were growing at 18 per cent per annum and GDP at 9 per cent per annum. People think that if the 18 per cent rise per annum slows, GDP growth will slow.

That is not true because you do not need a further rise in the investment rate. At 38.5 per cent, with an incremental capital-output ratio of 4, you need only 36 per cent rate of investment to get 9 per cent growth.

So a marginal slowdown will have no impact on growth from the supply side. From the supply side, capacity is being built. If your investment growth rate falls from 18 to 9 per cent, you will still maintain a figure of 38.5 per cent roughly.

If you look at the demand side, certainly something else has to grow - investment demand, private consumption, government, or net exports.

But here is the twist. On the demand side, if investment actually slows very sharply, having what people call a slightly expansionary fiscal stance will actually not be a bad thing, as in some ways it is a kind of demand.

Although I would not recommend it, as it will make the task of monetary management somewhat more difficult, this has a potential silver lining. If investment slows very sharply, of which there is no indication, then people will say this was actually a good thing.

I would not recommend it, because as I said, from a long-term supply perspective, it is not a good thing to have excessive fiscal deficit. There are, however, few indications of a sharp investment slowdown that would cause serious worry at this point of time.

Is it correct for the government to periodically ban commodity exports to control domestic prices?

I would speak as an economist and not as a defender of the government's view. In developed countries, there are a lot of markets, people have all kinds of options, and they would frown upon these things. Perhaps it was in your paper that somebody had criticised us. I would disagree. Because in India, when there is a very sharp increase, there is a case for moderating the increase to give time to people, the economic agents, to adjust.

The second factor is inflationary expectations. In our case, food prices and certain other commodities can have an impact on expectations. That is very unusual, as this is not something that happens in developed countries.

But in our case, we know, we have experience of this. So, if there is a very sharp change in prices of edible oils or cereals, there is not just the impact on the poor but also the impact on expectations that has to be watched.

So in case of all three commodity groups, we did act, and in my view, very rightly. However, a danger always exists of extending that over too wide an ambit.

In some cases, export duties were justified, in fact I have been pushing for them as a substitute for other policies such as export bans. For example, export duty on iron ore is justified as global iron ore prices jumped 66 per cent. In such a situation, the ideal measure is a resource tax, but we cannot do it because of legal limitations.

So the export duty is the second-best policy. Personally, one has to be very careful because somebody always gets hurt. And you have to balance the effects on both consumers and producers.

All policies cannot be in the interest of one segment. As I said, there is an economic justification for a change in trade taxes, where globally things change very sharply. On the other hand, when there are small changes, we have to be careful.

What is your assessment on growth this year?

As far as growth is concerned, in March, we had a forecast of 8-9 per cent. Information that has come since then is of three months of Index of Industrial Production data. There are some positive signs here.

Though the overall IIP is low, there is some recovery on the consumer side. The index shows weak capital goods production, but the CMIE (Centre for Monitoring of Indian Economy) data are still pretty strong.  Though the data are still being evaluated, I guess we will probably revise our expected range by 0.25 percentage points to 7.75-8.75 per cent.

Given the monetary steps taken, I am hopeful we will be back to normal inflation, that is 5-6 per cent, within 12 months. If I could be more confident about crude oil prices not going above some specific number, then I could give a projection.

What is your outlook on capital flows, given that the interest rate differential between India and overseas has widened?

Capital flows have jumped tremendously in the last quarter. Both FII (foreign institutional investor) and ECB (external commercial borrowings) are fairly volatile from month to month or quarter to quarter. FDI has been fairly steady. So this volatility means one cannot use the trend of one month or one quarter to predict for over a year.

When capital flows went up in January-March 2008, analysts went gaga saying it is going to go through the roof because the RBI's policy is all wrong. Next quarter it reverses and people start saying the opposite. As far as I can see, the broad trend over time, at least for the next several years, is that capital flows will keep going up.

There would be fluctuations. Now we are on a down move. That's why you have a depreciation of the rupee. It could reverse. But there is a lag in people's perception. People who talked about the appreciation of the rupee when capital was flowing in are still talking about it. I do not know how they can do that. The market balances are completely the opposite right now.

What is your assessment on the current account?

The import bill is going up. But if we look at history, the previous oil shock, we learn that oil importers like India are losing income but someone else is gaining. So oil exporting countries have more money. Their demand for imports will go up.

The oil shock is also an opportunity. Just as we did in the 70s, I am sure Indian industry will respond by raising their exports to these countries. At most, the current account may worsen for a little while, but I am pretty sure that with a lag, exports will pick up. The first three months of this fiscal are already showing a better performance.