Modi Raj Vs Modi Raj(an) Joining The Debate On Inflation Targeting



When I look at the euphoria in the markets, I am left wondering what people are expecting from the now-inevitable ‘Modi Sarkar’. It begs the question that Modi would have an agenda, a prescription to kick-start the economy and get the nation back on the rails.

Declaimer: This article written was originally in May 2014, and some of the data points may be outdated.

There was much that was wrong with UPA-II, but some that was right. The last 6 months have given little cause for complaint, within the constraints of the coalition that they were running. In particular, their choice of a trouble-shooting RBI governor and his subsequent actions have to be lauded.

When Modi comes in, he is expected to be a mature administrator, not another Arvind Kejriwal. The fact that the BJP has been in Govt before, gives us comfort that we will not have a Don Quixote with a dramatic agenda and some really ‘funny’ ideas on how to transform the nation.      

One area where there is a possible misstep is the area of inflation targeting. Rajan is focusing on dousing the fires of inflation by pouring the cold water of higher interest rates, while the BJP/Modi talks of digging the well (of supply-side debottlenecking) to get the water. Both are talking about using water to douse inflation, except that Rajan is more practical, in that he is dealing with what he has.

Both parties are doing better than what the UPA-II was doing, which was something akin to praying for rain. It looked like action, but it was little more than the wringing of hands, living on hope, and (like I said) a prayer. In a year of El Nino, this is a bad simile to use, but I wanted to emphasize my point.

One thing is clear, and I would give Rajan the credit for articulating it well…..a low-inflation environment is a pre-requisite for sustainable and steady growth. This seems to be seeping into the consciousness of our government of the day, whosoever it be. Other ingredients are also needed: productivity growth from technological change, low and falling debt: GDP ratios, high savings and investment, but that is later…..first, inflation is the petrol on the floor, which can burn down any economy, growing or not.

Modi should be carrying the flag for investment, and that will probably be his first achievement….to get the Investment Cycle restarted. That should create jobs and kickstart some of the ‘supply-side initiatives that will help douse inflation.

In doing this, no doubt, lower interest rates would help, but that is mainly to lower the Project Cost. There are other ways of doing this, higher equity and lower input costs (like land, equipment, etc.), for example.

But for immediate, short-term action that restores the credibility of the Rupee, there is nothing like demand management, i.e. douse excess demand anyhow. To the extent that excess demand is coming from a hyperactive investment cycle, raising interest rates is not a bad idea. But what when we have a drooping investment cycle (like just now) and you still have to use a blunt instrument like a general hike in Interest Rates?

In India, we do not have high consumer debt and not a major part of our consumption is funded by debt. Inflation anyway impacts consumption and reduces savings, thus bringing down investment. Higher interest rates could promote some savings at the margin, thus impacting some discretionary consumption. In this manner, higher interest rates affect both consumption and investment, thus affecting aggregate demand….this makes it growth-negative.

And this is what some voices in the BJP seem to be harping about, although such voices may have been prompted by pure politics. If you want the Investment Cycle kickstarted, you can use more direct methods (like lowering the cost of land acquisition, direct capital subsidies, and higher equity contributions in PPP projects), while giving Rajan the freedom he needs with his blunt instruments like Interest Rate and liquidity management.

For those among us who are scared that our 2 heroes will be at loggerheads on this issue, I would offer a fervent prayer ……….that Modi will pick up the economy by the bootstraps, focusing on very low-cost, ‘soft’ initiatives. The softest of these is inspirational (leadership) and the bolstering of sentiment, which he has already done admirably. Debottlenecking capacity in specific sectors, which have big multipliers (like food, water, and energy, besides infrastructure) is going to be next. The money for this can be found by bringing down most of the ill-conceived ‘doles’ that the previous Govt had installed; that is where most of his famed courage will come in useful. Bringing down the Fiscal Deficit to (let’s pray) under 3.2%, would release about Rs.1.5. lac crores for capital subsidies; these could be interest subvention for capital projects, direct capital subsidies in solar, for example, or high Govt equity in water-management projects in agriculture, or food processing.

Other minor initiatives would be the freeing of competition in agriculture, the introduction of corporate farming (with the requisite safeguards in minimum wages and labor laws), and the correction of the too-generous MSP regime that killed Congress through food inflation. The corporatization of agriculture would achieve many things at one go….a sharp rise in agricultural productivity, and investment downstream in the value chain (cold storage, value-addition, plantation farming, water management, solar-based energy, etc.). It would also enable taxation of the agricultural sector, a political impossibility just now. The contentious issue of the ownership of land could be done away with by freeing long leases and land ceiling laws.

We have seen in the case of the Brazilian sugar industry (and their many other agricultural initiatives), the dramatic transformation in Brazilian agriculture that followed corporatization. It will have an even more dramatic impact in India if Modi kicks off such transformational changes.

The Next 10 Years could see a structural shift in our political landscape, with the Congress vacating forever its ‘brand’, i.e. the sheen of the Gandhi name and the appeal of its left-of-center policies. Increasingly, the basis of political success will be governance, which means, inter alia, inflation control, jobs, and growth, perhaps in that order.

This is perhaps the first election where inflation (no, not even corruption) was the dominant reason why the ruling party has lost the elections, and a first-time challenger has taken center stage with such a handsome mandate. If he delivers, the next elections are his to lose. The BJP could emerge as the “Republican” party of India (just like the party of George Bush pursued right-of-center policies in the US. If the US has sometimes gone too far right, India has for long, gone too far left. If inflation is the bugbear of the dole-oriented policies of the Left, inequality rears up its head when you go too far right. Modi will have to protect himself from allegations of crony capitalism and lobby appeasement.

Any big argument is usually between 2 rights, not between a right and a wrong. The solution is, therefore, some appropriate shade of grey, which means different things to different people. Rajan’s recent initiatives may have been driven by the crisis he stepped into, and he has very successfully rebuilt the image of the country and the currency that he was given to manage. The credibility is hard-won, and should not be frittered away for temporary political gain. Building on his initiatives with some solid supply-side initiatives would be just what we expect from a man like Modi. If this is the Messiah that will lead India into the 21st century, then the least I would expect him to do is to recognize quality when he sees it.



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