Trap of stagflation

No lessons learnt from China

Ever since the BRICs’ study observed that India’s younger population made it possible for it to maintain a high growth rate further into the 21st century than China, many Indians have already begun to believe that India’s per capita GDP will one day catch up with and even overtake China’s. All that is needed to prick this balloon of illusion is to compare China’s response to the global recession with ours.

When China announced in Nov 2008 that it intended to pump an additional 4 trillion Yuan ($ 586 billion) into infrastructure and industrial projects to maintain its high growth rate, several China watchers received its commitment with polite disbelief. But by the end of March, a bare five months later, far more than the 4 trillion Yuan worth of new projects were already in the pipeline.

Chinese example

Under a new directive issued in November titled simply ‘Document 18, 2008,’ the central leadership informed the provinces that it intended to spend 1.3 trillion Yuan through its ministries and required them to submit projects worth the remaining 2.7 trillion to it for vetting and approval.  The document also promised them ‘block’ grants to fund a part of the cost of the approved projects and gave them permission to raise the rest through bank loans. The response of the local governments was staggering. Within six weeks, by the end of 2008, 18 provinces had submitted projects for approval worth 25 trillion Yuan, leaving Beijing with the unenviable task of choosing from among them and assigning priorities.

Implementation has followed even more swiftly. In the first quarter 2009 the total credit advanced by banks grew by 15.3 per cent of the nominal GDP. This was 10 per cent more than in 2008.  Local authorities have clearly not waited for central disbursements to reach them but have  gone ahead with their projects on the basis of bank loans that they intend to reimburse later.

While China has concentrated on reviving growth, India has remained preoccupied by a desire to control inflation, even though this has meant sacrificing growth. The preoccupation first arose  when the economy went into a boom in 2006 and led to seven successive increases in the cash reserve ratio between January 2007 and August 2008.

Not surprisingly, industrial growth fell from 12 pc in Jan to March 2007 to 4.7 pc in July to Sept 2008 on the eve of the global recession. In the next six months, industrial growth has been just about zero. The global recession has therefore been almost as cruel to India as to China. Despite this the government has continued to assign a higher priority to not allowing inflation to rear its head in the future than to kick-starting an economic recovery. When inflation turned negative in the first week of June 2009 for the first time in 30 years  the government reminded reporters that this was only because the change in prices was being measured from the peak of the commodity price-based inflation of the first months of 2008.

Far from seeing the disappearance of inflation as an opportunity to stimulate the economy the government warned the public that the pressure of consumer demand remained high. In its estimate inflation would pick up again towards the end of the year.

It would not therefore change its policies.

What both the Reserve Bank and the finance ministry are unwilling to admit is that their fight against the phantom of inflation has landed the country in the worst economic trap that can be imagined. This is the trap of stagflation. Two sets of data highlight the way India is caught in it: the prices of primary products, mainly agricultural, are still rising, and rural demand is propping up the sales of consumer goods as well as some raw materials such as cement. But the volume of bank credit is shrinking.

Credit contraction

Just as the jump in china’s investment has been heralded by a huge rise in bank lending, the onset of stagflation in India is being signalled by a contraction in the credit being advanced to borrowers by the commercial banks. A sharp contraction in Nov 2008 was brushed off by the Indian policy makers as an inevitable consequence of the shock administered by the global recession.

But the volume of credit has fallen again, in absolute terms by Rs 37,000 crore in the six weeks between April 10, and May 22. Most economists have come to the conclusion that  the corporate sector is still reluctant to invest because of the high cost of borrowing and is waiting for the budget in the hope of relief.

In real terms the cost of borrowed funds is not just high but unprecedented. In the 1999-2000 Economic Survey, Yashwant Sinha had signalled an imminent decline in interest rates by pointing out that real rates of interest had risen to an unprecedented 8 pc. In the past six weeks it has been 12 to 16 pc for different categories of borrowers.

The  government’s attempt to provide a fiscal stimulus to the economy without resorting to deficit financing has further tightened the stranglehold of stagflation. Although it has increased spending by no less than 7 pc of the GDP in an effort to stimulate demand, it has covered the rise by borrowing from commercial banks. In 2008-9 instead of issuing  government bonds worth Rs 133,000 crore it issued bonds worth Rs 326,000 crore. This flood lowered their prices and took the yield on them to a peak of 7 pc in Feb-March  2009. With yields still in the range of 6 pc, the banks feel no need to lower their prime rates. Stagflation is therefore locked in place.