Two recent news reports show that the policy deadlock between the Reserve Bank of India and the ministry of finance, that is driving the economy steadily deeper into recession, is all set to continue.
On Thursday, August 23 the Reserve Bank admitted, in its annual report for 2011-12, that investment had fallen by 46 per cent overall, and by 52 per cent in infrastructure, in the past one year.
Such a sharp single-year fall is probably unprecedented: for it was not experienced by the United States during the Great Depression of the 1930s. But despite this the RBI has virtually ruled out any cut in policy interest rates in the near future on the grounds that this will not suffice to revive investment.
The RBI hinted that it might cut rates if the government reduced its budget deficit, but on the same day finance minister Chidambaram ruled out any reduction of subsidies on transport fuels, on the grounds that this would have a cascading effect on food prices.
The deadlock is entirely unnecessary and has begun to look more and more like a battle for turf, for the government needs to do both. But the Reserve Bank is stubbornly minimising the depth of the recession in order to defend its past policies, and Chidambaram has been a shade too dismissive in concluding that a cut in subsidies will feed food inflation.
Only the willfully obtuse can claim that a revival is possible without a cut in interest rates. But that is precisely the RBI’s position. According to its analysts a rate cut is not necessary because it is only the nominal interest rate that appears high today. The real rate, which is obtained by deducting the rate of inflation from the nominal rate, is only 3.8 per cent. This is only half of what it was (7 per cent) during India’s industrial gold rush from 2003 to 2008: ergo the problem lies elsewhere.
There are too many flaws in this argument to enumerate, but the most obvious is that it can only hold good only when demand is robust and rising. Only then can the manufacturer be sure that he will be able to get a higher price for his products in the future. This assumption breaks down when demand is stagnant or declining but the cost of inputs is being pushed up by supply shortages.
The manufacturer’s only option then is to reduce his other costs frantically by laying off labour, squeezing real wages or shaving his profit margin.
That is what industry did during the last recession, from 1998 till 2003.That is what it is doing again today. In the last three years (ending July) the price of non-food primary products – a group that includes almost all industrial raw materials – has risen on an average by 14.7 per cent a year, but the price of manufactures has risen by only 6.4 per cent.
If we exclude steel, cement, and edible oils, which have seen greater increases because of global demand, the price rise in the rest of industry has been below 6 per cent rise. Most of even this has been forced upon it by the increased cost of food and industrial raw materials, the 25 per cent devaluation of the rupee, and the higher interest charges on working capital.
With minimum lending rates currently at 10.5 to 15.75 per cent, the real rate of interest for all but the above three industries is therefore not 3.8 but anywhere from 8 to 14 per cent. Only the foolhardy would borrow money for investment at such rates!
India, however, needs not only much lower borrowing rates but also a sharp cut in budget deficits to reduce government borrowing and free more money for private investment.
That is why a cut in subsidies is essential. Chidambaram’s fear of a cascading increase in food prices is unwarranted, for he must know that the impact of a diesel price increase can easily be offset by releasing more of the 76 million tonnes of food stocks it now holds in its storage sites into the open market. This has, in any case, become necessary because although the output of food grains has risen by an average of 26 million tonnes in the past four years state governments have prevented market prices from falling by buying up the whole of the increase at steadily escalating procurement prices and dumping it on the FCI. This cannot go on forever.
Invalid stereotypes
Underlying Chidambaram’s immediate rejection of hike in diesel prices is the political classes’ firmly embedded belief that reducing any subsidy, whether on food or fuels, will cost it the next election. But the stereotypes that have governed our perceptions and policies ever since Independence are no longer valid.
Structural changes in the economy over the past quarter-century, distortions introduced into what were originally simple and effective schemes of subsidy, and all –pervasive corruption in their administration, have created a situation in which it is possible, through appropriate reforms, to simultaneously increase the delivery of benefits to the poor and sharply reduce the government’s subsidy bill.
A 2005 study of the Targeted Public Distribution System (TPDS) by the Planning Commission showed that those below the poverty line (BPL) were receiving only 14.6 kg a month , i.e. 40 per cent, of the subsidised rations they were entitled to. The Central government was therefore spending Rs 3.65 to transfer one rupee of subsidy to the poor. Most of the balance was being appropriated by the ration shop owners who were selling the remaining 20 kg on the free market at an average profit of Rs 14 per kg.
Since there are 65.2 million BPL cardholders, this means that the Central government has been handing over Rs 21,900 crore a year of the taxpayers’ money to a criminal class! And then it wonders why inclusive development is not getting it votes!
Replacing the Targeted Public Distribution Scheme with a system of food stamps, or coupons, encashable at the existing ration shops, as was suggested in the Economic Survey for 2009-10 and earlier by Chidambaram himself, will increase the food that BPL families are able to buy by one and a half times, while simultaneously reducing the subsidy bill. The current subsidy on food supplied to BPL families amounts to Rs 27,300 crore.
If the remaining 25 million ration card holders also receive food stamps worth half the market price of 35 kg of foodgrains, the additional subsidy will be no more than Rs. 8,400 crores. Thus even after adding the cost of mailing food coupons or, should the government prefer it, making cash transfers through banks and post offices, the government will still save more than Rs 30,000 crore out of the present subsidy bill of Rs 72,300 crore.
The second area in which it is possible to prune subsidies drastically while gaining political approbation, is in transport fuel pricing. The way to do this is to not merely raise the price of diesel but simultaneously lower that of gasoline. Diesel is no longer solely the poor man’s transport fuel, and petrol is most definitely no longer the preserve of the rich.
Symptomatic of the change is that while passenger buses accounted for 12 per cent of the 60 million tonnes of diesel that was consumed last year, passenger cars accounted for more than 15 per cent. This is not entirely surprising because two out of five cars being manufactured in India today have diesel engines.
Price-sensitive sector
Truck transport, which accounts for just over a third of consumption, is the most price-sensitive sector, as diesel fuel makes up an estimated 40 per cent of its operating costs. But since transport costs seldom account for more than 10 per cent of the retail price, a 25 per cent hike in diesel price will translate into, at most, a one per cent rise in the cost of living.
On the other hand three out of ten of India’s 247 million households depend upon gasoline fuelled vehicles for their transport — 55 million on two-wheelers and 12.3 million on cars. Unlike diesel prices, that affect the cost of living only indirectly through the production chain, petrol price hikes impact household consumption directly. Assuming that the average scooter or motorcycle owner uses one litre of petrol a day, the Rs 25 rise in the price of petrol in the past two years has reduced his household’s disposable income by Rs 750 a month. This could partly explain the fall in the UPA’s popularity revealed by the municipal elections in Delhi last April, and last week’s poll by a TV channel.
Every crisis therefore contains within it the seeds of opportunity. The UPA government has a once-in-a-lifetime chance to simultaneously revive the economy, refurbishing its tarnished image at home and abroad; correcting the huge distortions in its subsidy regime and regaining the popularity it has lost. All it needs to do is raise the price of diesel by Rs10 a litre and lower that of petrol by an equal amount and transfer food benefits in the form of cash or, preferably food stamps and coupons.
Deccan Herald is on WhatsApp Channels| Join now for Breaking News & Editor's Picks