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8/2/2019 Economy Insight-Putting the Lid on Inflation_March 2012
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Putting the lid on inflation
March 2012
KINGA MM ARKETSF
UNCTIONBETTE
R
YEARS
CRISILInsight
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CRISIL Insight
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Putting the lid on inflation
A report by CRISIL Centre for Economic Research
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Analytical contacts
Dharmakirti Joshi
Vidya Mahambare
Dipti Saletore
Chief Economist [email protected]
Senior Economist [email protected]
Economist [email protected]
We would like to acknowledge the contribution of Krishnan Sivaramakrishnan,
Suresh Salunkhe, Rahul Srinivasan, Harshal Bhavsar and Rashmi Parab who
helped in preparing the report.
CRISIL Insight
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Key messages
Immediate steps to reduce and stabilise inflation at lowlevels
How and why of high and persistent inflation
n Fiscal consolidation with a focus on increasing investment spending
- Develop a credible roadmap to reduce the fiscal deficit to GDP ratio
- Reorient government spending from consumption to investment to
remove supply-side bottlenecks
n Productivity improvements in bottleneck areas
- Implement policies to improve farm productivity
- Step up efforts at skill development in sectors that face acute skill
shortages- Devise mechanisms to link wages to productivity in the public sector
and in government safety-net programs such as the Mahatma Gandhi
National Rural Employment Guarantee Scheme (MGNREGS)
n Reduce shocks from sudden changes in administered prices of petroleum
fuels, by aligning them to global prices.
n The Indian economy appears caught in a high-inflation trap. Per-year WPI
(wholesale price index) and CPI (consumer price index) inflation rose to 6.9
per cent and 9.0 per cent over April 2006 to January 2012, from 4.7 per cent
and 4.1 per cent in the preceding five years. No matter how you measure it,
inflation has been high over the past six years.
n Adverse shocks from shortfall of food articles, and higher global fuel and
commodity prices triggered inflationary pressures. Persistence in inflation,
however, originated from government policies that stimulated consumption
demand but did not do enough to raise the supply potential of the economy.
n MGNREGS, sharply increased wages for rural workers from 2007. These
wage increases, which were not linked to productivity improvements, added
to inflationary pressure. This coincided with wage increases in the public
sector and in the private sector (arising from skill shortages) which
generalised inflation.
n Inflation inched further up in 2010-11; despite monetary tightening,
inflationary pressures continued in 2011-12. A series of interest rate
increases by the Reserve Bank of India (RBI) attempted to curb demand,
which the higher fiscal deficit fired by consumption-oriented spending
continued to spur. The nature and quantum of fiscal spending thus muted the
effectiveness of the monetary policy.
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CRISIL Insight
Contents Page
Key messages 1
Objective of the paper 3
Part I - How and why of high and persistent inflation 4
Inflation in India moves up 4
Fiscal policy fans inflation 5
Government policies fuel wage rise across income categories 7
Inflation-indexation of wages aggravate inflationary pressures 8
Rising demand sparks inflation in supply-deficient categories 11
Inflation becomes persistent and generalised 15
Monetary policy against backdrop of expansionary fiscal policy -
ineffective in inflation control 15
Part II - Key recommendations 17
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Objective of the paper
This paper identifies the steps that the government should take to reduceand sustain inflation at close to 5 per cent.
The recommendations draw upon an analysis of recent drivers of inflation in
India. The paper acknowledges the role of adverse supply shocks in
triggering inflationary pressures. More importantly, it emphasises the role of
government policy in accentuating the pressure on inflation.
Part I of the paper explains the recent drivers of persistent inflationary
pressures in the economy. Part II lists our key recommendations and their
underlying rationale.
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Part I - How and why of high and persistent
inflation
Inflation in India moves up
Inflation in India has remained high and persistent in the last six years. As the
Indian economy grew at an unprecedented rate of almost 8.5 per cent during
the period, rising incomes propped the purchasing power of the population,
driving consumption demand. The surge in demand triggered inflationary
pressures, particularly in sectors where supply lagged behind. Gradually,
inflation became generalised, as public policy continued to spur growth in
consumption demand and wages.
Inflation is the increase in the average prices of a basket of goods and
services, measured by an index. There are three measures of inflation in
India: WPI, CPI, and the gross domestic product (GDP) deflator. The third
measure is the most comprehensive, as it takes into account all goods and
services produced in the economy. All three measures reveal signs of an
early pick-up in inflation in 2006-07 and persistence thereafter (Table 1).
WPI inflation consistently surpassed the RBI's comfort threshold of 5 per cent
in 51 of the 70 months between April 2006 and January 2012. It averaged 6.6
per cent over 2006-07 to 2010-11, rising from 4.7 per cent during the previous
five years. CPI inflation, over the same reference period, rose to 9.0 per cent
from 4.1 per cent, and inflation measured by the GDP deflator climbed to 7.4
per cent from 3.9 per cent. During April 2011- January 2012, CPI and WPI
inflation averaged 8.8 per cent and 9.1 per cent; inflation measured by the
GDP deflator averaged 8.2 per cent in 2011-12. Regardless of how you
measure it, inflation in India has become high and persistent (Table 1).
Note: Inflation 5% = red.
*: Data for WPI and CPI is April to January 2011-12.
1. The three measures of inflation vary in coverage. CPI includes some services and assigns higher weight to food prices, whereas
WPI assigns higher weight to manufactured products. Inflation measured by the GDP deflator covers all goods and services in the
economy.
2. WPI inflation dropped sharply in 2009-10, as fuel and commodity prices - the significant component of the index - collapsed
following the Lehman crisis.
Source: Ministry of Industry, Ministry of Labour, Central Statistical Organisation, CRISIL Research
Table 1: Persistence in inflation
Measures of inflation 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12*
WPI based 3.6 3.4 5.5 6.5 4.4 6.6 4.7 8.1 3.9 9.6 9.1
CPI based 4.3 4.1 3.8 3.9 4.2 6.8 6.2 9.1 12.4 10.4 8.8
GDP deflator-based 3.0 3.8 3.4 5.5 4.1 6.4 6.0 8.1 7.3 9.9 8.2
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The past six years, since 2006-07 were punctuated with a series of adverse
supply shocks. The shocks arose from a shortfall in food-grain and non food-
grain commodities (vegetables, fruits, protein-based foods - pulses, milk,eggs, meat and fish). Sharp increases in international prices of fuels and
commodity too were a trigger. Persistence in inflation, however, did not arise
from supply shocks. Although supply shocks can trigger sudden and sharp
inflationary pressures, the pressures diminish when supplies revive.
Persistence in inflation stemmed, instead, from government policies that
stimulated consumption demand by increasing wages and salaries but did
not do enough to remove supply-side bottlenecks. Under fiscal policies that
boosted consumption, the supply shocks had a more lasting effect,
reinforcing inflationary pressures.
Inflation was generalised; all the categories of the WPI contributed to
inflationary pressures. Food inflation, however, was the most stubborn. It
averaged 10.2 per cent over 2006-07 to 2010-11, and prevailed at over 15
per cent in the last two years of the period. Manufacturing inflation averaged
5.3 per cent, whereas fuel inflation averaged 10.2 per cent over the five-year
period. Although food inflation has declined significantly since December
2011, it is likely to bounce back once the impact of seasonal factors and the
effect of high base wear off.
Fiscal policy is the means by which a government adjusts spending and
taxation to influence demand and the economy's capacity to produce goods
and services. In India, an expansionary fiscal policy (through cuts in taxes,
increase in government expenditure) has boosted consumption demand in
recent years.
Consumption expenditure of the government increased by ` 5,300 billion
between 2004-05 and 2010-11, in comparison to an increase of` 1,800
billion in expenditure on capital formation (Figure 1). Of the total direct
government consumption expenditure, wages and salaries accounted for
almost 50 per cent.
Since 2008-09, the government expenditure focused more on boosting
consumption demand in the short term, than on improving the economy's
productive capacity. During the global financial crisis, the government
provided fiscal stimulus in the form of indirect tax cuts and increased
expenditure. Although the tax stimulus was partially withdrawn as the
economy recovered, the increased spending to boost consumption demand
continued even after the crisis.
Fiscal policy fans inflation
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CRISIL Insight
Note: Consumption expenditure includes direct consumption expenditure and current transfers.Capital formation includes capital formation by the central government and financial assistance for
capital formation to the economy.
Source: Ministry of Finance and CRISIL Research
The rapid growth in consumption expenditure drove up total government
expenditure, increasing the fiscal deficit. Fiscal-deficit-to-GDP ratio
averaged 5.8 per cent in the post-crisis period (2008-09 to 2010-11),
compared to the initial target of 3.0 per cent set by the Fiscal Responsibility
and Budgetary Management Act (FRBM). In 2011-12 we expect the fiscal
deficit to slip to 5.5 per cent of GDP vis--vis a budget target of 4.6 per cent
(Figure 2).
The higher fiscal deficit and inadequate focus on expanding productive
capacity laid the breeding ground for inflation.
0
2,000
4,000
6,000
8,000
10,000
2004 -05 2005 -06 2006 -07 2007- 08 2008 -09 2009 -10 2010 -11
`billion Consumption expenditure Capital formation
Figure 1: Central Government expenditure on consumption and capital formation
Note: *CRISIL Research estimates
Source: Budget documents
4.04.1
3.5
2.7
6.06.4
5.15.5
2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12*
Fiscal Defit to GDP, %Figure 2: Building fiscal stress
Fiscal deficit/GDP, %
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Government policies fuel wage rise across income categories
The sharp increase in wages which was near simultaneous across income
groups in urban and rural India since 2004-05 (Box 1) boosted consumptiondemand. Urban and rural wages rose by 12.0-14.0 per cent over 2004-05 to
2009-10, compared to an increase of 7.0 per cent in the previous five-year
period. Increases in income were especially sharp after 2007-08 (Figure 3).
After the implementation of MGNREGS, rural wage growth gained
momentum. Since 2007-08, rural wages rose faster than the inflation rate, as
indicated by the sharp rise in real wages (Figure 4).
Source: National Sample Survey Organisation (NSSO)
Note: Nominal wages have been de flated by CPI for agricultural wokers
Source: NSSO
Figure 3: Near-simultaneous increase in wages across income groups
4.3 3.81.4
3.3
7.3
1.7
6.7
11.0
24.2
29.9
19.217.3
Rural casual Urban casual Rural Regular Urban Regular
Average annualgrowth nominal,%
yoy
1999-00 to 2004-05 2004 -05 to 2007-08 2007-08 to 2009 -10
Figure 4: Increase in rural wages
1.3 1.8
8.8
13.7
Regular Casual
Rural
Average annual
growth real,% yoy2004-05 to 2007-08 2007-08 to 2009-10
The rise in urban wages was an outcome of three factors: first, the supply of
skilled labour did not increase in line with demand; second, theth
implementation of the 6 Pay Commission recommendations increased
public sector wages; and lastly, rising demand for corporate- and household-
support services drove up wages of urban casual workers almost twofold.
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CRISIL Insight
Such sharp wage increases, which more than compensated for inflation, had
no explicit link to productivity improvement. Wage growth without productivity
improvements is a recipe for inflation.
The wages of a large section of workers in the economy rise in line with
inflation. Wages in the public sector are linked to inflation. In February 2011,
the government also linked wages under the MGNREGS to inflation. As
MGNREGS - wages have become the benchmark floor for rural wages,
wages of other rural workers too increase along with inflation.
The linkage between wages and inflation through MGNREGS will spread a
wage-price spiral across sections of the economy. As the wage-price spiral
threatens to fuel growth in consumption demand across the economy, it is
critical to link wage increases to productivity, to augment supply in line with
rising demand.
Inflation-indexation of wages aggravate inflationary pressures
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Box 1: Wage increase across income categories
n Incomes in rural India increase rapidly
The need to increase incomes of unskilled rural population became pressing for the government, given
insufficient job opportunities in rural areas, despite a period of high economic growth. Policymakers therefore
extended the social security scheme MGNREGS (initiated in February 2006) to all of rural India in 2008-09. This
scheme had two effects: first, it set the benchmark for wages of farm as well as non-farm rural workers (Figure
5); and second, it created a shortage of agricultural labour since workers were reluctant to migrate to other
states for farm employment. This shortage pushed up wages of agricultural workers further.
n Incomes of the urban salaried-class increased
- Skill shortage drove up wages of urban skilled labour.
Knowledge-based services (information technology) and high-skill manufacturing industries
(automobiles and pharmaceuticals) drove the rapid economic growth of over 8 per cent during 2003-04 to
2007-08. According to the Planning Commission (12th Plan Approach, page 16), rapid growth has been
accompanied by shortage of specific skills and increasing rates of employee turnover. As per a FICCI
survey conducted during August-September 2011, about 90 per cent of the respondents (largely from
industries engaged in high-skill manufacturing) ci ted shortage of skilled labour as a serious problem; 82
per cent of the respondents said that labour shortage was the reason for at least 10 per cent of wage
increase in their firms. Knowledge-based services recorded significant increases in wages. Average
wage-to-sales ratio in information technology rose by a sharp 39 per cent in recent years (Figure 6).
Source: NSSO
Figure 5: MGNREGA wages set a rural benchmark
59
49
8993 93
MGNREGA Public works other than
MGNREGS
Rural casual
Wages per day, `
2005 2010
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- Public sector wages rise.
Wages of public sector employees, who account for almost a fifth of organised employment in India, rose inth
2008-09 (Figure 7) in line with the recommendations of the 6 Pay Commission. (The government revises
public sector wages every ten years.) In addition to a permanent increase in salaries, public sector
employees also received lump-sum cash payments as arrears. In real terms too, public sector wages rose
by 11.8 per cent during 2007-08 to 2010-11 compared to 1.6 per cent in the previous 4 years.
Source: Ministry of Finance
Note: The values for annual wages exclude travel allowances in 2008-09 and 2009-10
n Wages of urban casual workers rise
The increased incomes of the urban salaried-class and strong performance by the corporate sector drove up
demand for corporate- and household-support services. Wages of people providing these services therefore
rose. Data from the National Sample Survey Organisation (NSSO) show that wages of urban workers employed
in casual jobs almost doubled to `122 per day from`69 per day between 2004-05 and 2009-10.
Figure 7: Public sector wages per person
8495 97
107115 121
138
187
244
267
2000-01 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11
Annual wages in '000`
Source: CMIE Prowess Database, CRISIL Research
Figure 6: Wage pressure in information technology sector
37.0
38.0
39.0
40.0
41.0
42.0
Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep -10 Mar-11 Sep-11
Salary to total sales (%, 4 quarter moving avg)
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Rising demand sparks inflation in supply-deficient categories
The rapid wage growth drove up average spending by the population over
2004-05 to 2009-10, compared to the previous five years. As per data from
the NSSO surveys, the average nominal per-person expenditure rose from
3.6 per cent to 10.5 per cent per year in rural areas and from 5.3 per cent to
10.9 per cent per year in urban areas, during the reference period.
Although demand for almost all goods and services rose, an analysis of the
pattern of inflation based on GDP data reveals that price increases were the
sharpest for food items, real estate, public administration (cost of
government services) and social and personal services (healthcare and
education). These sectors are dependent on domestic policy actions
(Figure 8). Prices of consumer durables and telecom services, by contrast
sectors that face competition from imports did not rise as fast; prices of
certain consumer durables (microwave ovens, TV sets, computers and
video CD players) even declined during the period.
Note: CS refers to community and social economic services
Source: Central Statistical Organisation, CRISIL Research
Price increases in agricultural commodities food grains and non food-
grains averaged more than 11 per cent over 2006-07 to 2010-11, driving upoverall inflation. Three factors sparked the sharp increase in the prices of
agricultural commodities (Box 2): first, agricultural supply did not rise
adequately to meet the rising demand; second, minimum support prices
increased sharply; and third, global food prices rose and food imports could
not bridge the shortfall in domestic supply.
Prices of real estate, education and healthcare services too rose rapidly by
10.2 per cent between 2006-07 and 2010-11, from 4.9 per cent over the
previous five-year period. Domestic supply of these services could not keep
pace with rising demand. And, the nature of these services made the
possibility of imports remote.
Figure 8: Inflation dynamics across sectors
4.6
(7.9)
3.9
4.9
3.4
4.2
6.9
4.3
2.2
10.2
2.5
5.1
(10.2) 12.3
12.3
8.9
8.38.0
6.4
0.2
8.7
0.9
Manufacturing
Communication
Agriculture
Real Estate & Business Services
CS Services Ex Pub Admin & Def
Publ Admin & DefenceConstruction
Trade, Hotels,Trans, Storage
Banking and Insurance
Mining
Linked to
technology
and trade
Domestic-led
AdministeredElectricity, Gas and Water supply
%, yoy 2006-07 to 2010 -11 2001-02 to 2005-06
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CRISIL Insight
For utilities (electricity, cooking gas and domestic fuels, and water),
administered prices artificially suppressed inflation even as demand
pressure increased. The administered prices of utilities do not reflect theirtrue cost, with the exception of certain deregulated fuel categories, such as
petrol. Consumers therefore face less pressure to rationalise energy
consumption. Producers, given their inability to charge market-determined
prices, have to depend more on transfers from the government to
compensate for under-recoveries from consumers. The increasing subsidy
outgo on fuel adds to fiscal pressure. When the subsidy burden becomes
unsustainable, the government is forced to increase retail prices of fuels.
Such revisions can at times be sudden and sharp.
Prices of consumer durables and telecom services did not rise as fast as in
food items, despite the increased consumption of these products by middleand upper income groups. During 2005-06 to 2010-11, for instance, prices of
microwave ovens, TV sets, video CD players and computers fell by 3.3 per
cent, on an average.
An increase in supply potential kept a lid on consumer durables inflation.
Domestic capacities increased and imports rose simultaneously to meet the
rising demand for these manufacturing products. In technology-related
services such as telecom services, healthy competition arising from
openness in international trade and investment-friendly government polices
expanded supply potential and lowered prices.
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Box 2: Factors influencing agriculture price increases
The three factors that sparked the sharp rise in prices of agricultural products:
n Agricultural supply did not rise adequately to meet the rising demand.
Growth in agricultural production was volatile and, at 3.3 per cent average, fell short of the government target of 4.0
per cent over 2006-07 to 2011-12. Growth in food-grain production has lagged behind population growth for the past
20 years. Over 1990 to 2010, food-grain production grew annually by 1.6 per cent compared to an average annual
population growth of 1.9 per cent. While demand for food articles increased, per capita net availability of food grains
per day declined from 510 grams in 1991 to 439 grams in 2010. This mismatch exerted a persistent pressure on food
prices (Figure 9).
Source: Central Statistical Organisation and CRISIL Research
Figure 9: Widening demand-supply gap for food is exerting persistent pressure on prices
90.0
135.0
2005-06 2007-08 2009-10 2005-06 2007-08 2009-10
180.0
Price movement
2004-05 = 100Agriculture Manufacturing Services
90
150
210
Output movement
2011-122011-12
Stagnant productivity is the key reason for inadequate increase in farm production. For instance, in 2010-11, the per-
hectare yield in Punjab fell to 3.8 tonnes, from 4.03 tonnes over 2005-06 to 2009-10. Given the stagnant productivity,
the National Food Security Bill, 2011, which will raise demand for food-grains, is likely to become another source of
pressure on inflation.
Production of non food-grain items pulses, vegetables and fruits, milk, eggs, meat and fish could not cope with the
sudden and sharp increase in the consumption of these products. The insufficient supply led to a sharp rise in prices
of these items. While nominal household expenditure (not adjusted for inflation) on protein-rich items milk, eggs,
fish and meat products rose by a sharp 14.0 per cent per year after 2004-05, real household expenditure on these
items rose at a much less 3.8 per cent (Figure 10). The increase in nominal expenditure was thus largely an effect of
rising prices.
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Despite an increase in vegetable and fruit production since 2004-05, the supply of these items fell short of demand. Inefficient
supply chain management adds to output and price volatility. A recent CRISIL Research report (August 2010) titled 'Retail FDI
to reduce fruit and vegetable wastages' observed that around 30 per cent of fruit and vegetable production (valued at Rs 630
billion) went waste in 2009-10 for lack of storage and transport infrastructure.
The need to increase both food-grain and non food-grain production will become stronger, if the Indian economy is to grow at
9.0 per cent per year. The Planning Commission estimates in its 12th Plan Approach paper that, to support a GDP growth of 9.0
per cent, agricultural production will have to grow by 4.0 per cent over 2012 to 2017.
n Sharp increases in minimum support price (MSP)
Increases in MSPs for food grains, especially wheat and rice, have been more substantial in recent years (Table 2). MSPsare based on a cost-plus formula the sharp rise in agricultural input costs since 2008-09 (Table 3) therefore made
increases in MSPs unavoidable and drove up the market price for food grains.
Source: Central Statistical Organisation, CRISIL Research
Figure 10: Household expenditure on milk, eggs, meat and fish
-1.0
4.0
9.0
14.0
19.0
2000 -01 2002 -03 2004 -05 2006 -07 2008 -09 2010 -11
%, yoy Nominal growth Real growth
n High global food prices
Global food prices have risen sharply by 14.1 per cent during 2007 to 2011. As per the joint study by Organisation for
Economic Co-operation and Development, and Food and Agriculture Organisation (OECD-FAO), agricultural
commodity prices are expected to remain elevated in the 2011 to 2020 decade. The rising global food inflation precludes
the option of bridging the domestic demand-supply gap in food through cheap imports.
2002-07 2007-12
Paddy 2 12
Wheat 4 13
Source: Agricoop, Ministry of Agriculture
Table 2: Average Annual percentage increase in MSP Table 3: Percentage increase in Agricultural input prices
2008-09 2009-10 2010-11
Inputs* 3 to 19 18 to 28 3 to 19
Wages 9 to 36 5 to 30 18 to 43
Note: *Inputs are fodder, diesel oil, lubricants, fertiliser, pesticides
Source: D. Subbarao, (2011) The Challenge of Food Inflation
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Inflation becomes persistent and generalised
As demand continued to rise, backed by wage increase, inflationary
pressures became widespread (Table 4). By 2010-11, inflation had risen in
almost all the components of WPI. Core inflation (non-food manufacturing),
reflecting demand-side pressure, started rising from 2006-07, and
accelerated after a transient decline in 2009-10.
Monetary policy against backdrop of expansionary fiscal
policy ineffective in inflation control
The key goal of monetary policy is to maintain demand at a level that keeps
inflation low and stable. For India, the objective of monetary policy is to keep
inflation at 5.0 per cent in the near term and eventually move towards 3.0 per
cent. This objective has been belied as WPI inflation has averaged 6.6 per
cent since 2006-07, and above 9.0 per cent in 2010-11 and 2011-12.
A series of interest rate increases by the Reserve Bank of India (RBI)
attempted to curb demand (Figure 11), which the higher fiscal deficit fired by
consumption-oriented spending continued to spur. The nature and quantum
of fiscal spending thus muted the effectiveness of the monetary policy.
Table 4: How inflation became generalised
WPI Inflation 3.6 3.4 5.5 6.5 4.4 6.6 4.7 8.1 3.9 9.6 9.1
Food (primary + processed) 2.0 3.0 4.1 3.5 5.4 9.6 7.1 9.1 15.2 15.8 7.3
Fuel 9.3 5.5 6.4 10.1 13.6 6.6 0.1 11.7 -1.7 12.3 13.7
Non-food manufacturing 2.2 2.2 5.0 6.5 2.6 5.7 5.0 5.7 0.2 6.1 7.6
Note: Inflation 5% = red. *: Data is from April to January 2011-12
Source: Ministry of Industry and CRISIL Research
Source: RBI
Figure 11: Monetary policy actions
3.0
5.0
7.0
9.0
11.0
%
Feb -10 May-10 Aug -10 Nov-10 Feb -11 May-11 Aug -11 Nov-11 Feb -12
Marginal Standing Facility Rate: 9.50
Reverse Repo Rate:
7.50
Repo Rate: 8.50
2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12*
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CRISIL Insight
Inflation can fall below 5.0 per cent temporarily if supply shocks recede - if, for
instance, seasonal factors suddenly increase the supply of agricultural
products or international oil prices plunge. To stabilise inflation at less than
5.0 per cent, however, fiscal restraint and measures that enhance the
economy's productive capacity will be required. It will also be critical to link
wage growth across income classes to productivity improvements. Such an
alignment will ensure that demand in the economy, fuelled by income rise,
does not race ahead of supply.
Since monetary policy is forward looking, accurate forecast of inflation is
critical for inflation management. Sudden and sharp increases in
administered fuel prices, for instance, throw inflation forecast out of gear.
Our analysis finds that government policy has played a critical role in
accentuating inflationary pressures. In the next part of this report, we
therefore recommend changes in the policy that would enable the RBI to
reduce and stabilise inflation in India at around 5 per cent.
Concluding remarks
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Part II Key recommendations
This section outlines the three most critical recommendations for assistingthe RBI's efforts to sustain inflation at less than 5.0 per cent.
There is an urgent need to reduce the fiscal deficit-to-GDP ratio to a pre-
defined target and restore fiscal discipline. The government should
announce credible targets for deficit reduction in the Union Budget 2012-13,
and lay out a plan to achieve the targets. The reduction in fiscal deficit will curb
demand pressure on inflation.
The composition of government expenditure needs to lay greater emphasis
on increasing the productive capacity of the economy, through increased
investments in agriculture, education and infrastructure. To create fiscal
space to invest in these critical areas, the government will have to reduce
subsidies.
The subsidy bill has increased in the past few years, and currently accounts
for 12.0-13.0 per cent of the total expenditure. Fertiliser and oil subsidy bills
account to 54.0 per cent of total subsidy. CRISIL Research estimates that for
2011-12, fertiliser and oil subsidy bills could balloon to at least Rs 1,500
billion, twice the budgeted target. The sharp increases in subsidies would
narrow the fiscal leeway. Food subsidy is likely to increase if the government
introduces the Food Security Bill next year. An appropriate fiscal policy that
financially supports efforts to improve agricultural supply potential therefore
becomes critical.
The fiscal policy will also have to focus on increasing the availability of skilled
labour, and developing infrastructure which will enhance the growth potential
of the economy over the medium term and stabilise inflation within 5.0 per
cent.
Increasing agriculture productivity will be the surest way to taming food
inflation. Stepping up farm yields will need better irrigation, technology and
infrastructure, all of which will hinge on the government's ability to provide
fiscal policy support.
Fiscal consolidation with a focus on increasing investment
spending
Develop a credible roadmap to reduce fiscal deficit-to-GDP ratio
Reorient government spending from consumption to investment to remove
supply-side bottlenecks
Productivity improvements in bottleneck areas
Implement policies to improve farm productivity
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Step up efforts to accelerate skill development in sectors where acute skill
shortages are driving up wages.
Devise mechanisms to link wages to productivity
Reduce shocks from sudden changes in administered prices of
petroleum fuels
Wage increases in the knowledge-based services sector stem from a
shortage of skilled labour. Fast-track reforms in education that can alleviate
the skill shortage will be the key to rationalise wage growth in this sector.
Wage growth that enables people to cope with rising inflation is a desirable
policy outcome. It is, however, critical to design policies that align wage
growth with improvements in quality, productivity and capacity creation.
- Redesign social sector schemes to enhance farm productivity
Tighter monitoring of projects under the MGNREGS will ensure that
farm productivity improves. Currently, even though the scheme focuseson improving irrigation and rural water supply, ineffective
implementation of the scheme has fetched sub-optimal results.
According to the Planning Commission (12th Plan Approach paper,
page 5) with better project design under MGNREGS implementation,
leakages could be greatly reduced; and the assets so created could
make a larger contribution towards increase in land productivity.
The MGNREGS needs to be transformed into more than an
employment guarantee scheme. Coverage under the scheme should
be restricted to 3-5 years per individual; and the scheme, during this
period, should give the beneficiary incentives to improve farmproductivity or develop skills. This would increase the base of skilled
people and reduce burden on the exchequer.
Rural people who do not own farms can under skill development
programmes gain access to basic training for low-skilled manufacturing
jobs or jobs allied to farming. Vocational training can reduce the rural
population's dependence on agricultural income and on schemes such
as the MGNREGS. It will also enable the rural population to take up
work in relatively low-skilled manufacturing industries, which the
recently announced National Manufacturing Policy aims to create.
- Link a portion of public sector wages to performance
Linking a part of public sector wages to performance, a standard
practice in the private sector, will ensure that productivity gains
accompany wage increases.
Accurate forecasts of inflation are the key to inflation control since an
increase in the interest rate affects prices with a substantial lag. Inflation
forecasts can become more accurate if the government reduces the surprise
CRISIL Insight
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element in administered price changes.
Aligning international and domestic prices of petroleum fuels will reduce the
surprise element in changes to administered prices. This policy action will
also reduce the subsidy burden and rationalise demand for these products.th
According to the Planning Commission (12 Plan Approach paper, page 31),
diesel, kerosene and LPG prices are currently at least 20.0, 70.0 and 50.0
per cent less than the level, if they were aligned to international prices.
Monetary policy will remain less effective in inflation control, if fiscal policy
does not focus on improving supply of key goods and services agriculture,
skilled labour and infrastructure but keeps stimulating consumption
demand.
Increasing agricultural productivity will require the policy to foster a
supportive environment of better irrigation, better technology and
infrastructure. Linking wages to productivity will be critical for managing
demand pressures.
Increasing productivity will enable the economy to control inflation and enjoy
higher growth. Else, the economy could lapse again into a phase of lower
growth.
Concluding remarks
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CRISIL Insight
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CRISIL Insight
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