💥Join UPSC 2027,2028 Mentorship (July Batch) + XFactor Notes & Microthemes PDF
Talk to Mentor

Civilsdaily

Login

GS Paper: Indian Economy

  • GST Council must uphold fiscal federalism

    Context

    The recent ruling of the Supreme Court held that the states were free to use means of persuasion ranging from collaboration to contestation.

     Simultaneous or concurrent powers under Article 246A

    • Article 246A confers simultaneous or concurrent powers on Parliament and the state legislatures to make laws relating to GST.
    • This article is in sharp contrast to the constitutional scheme that prevailed till 2017.
    • It clearly demarcated taxing powers between the Centre and states with no overlaps.
    • After 2017, several central and state levies were subsumed into GST.
    • Each state was to have its own GST Act, all of them being almost identical to the Central GST Act.
    • Inter-state supplies and imported goods are liable to IGST.

    Composition of GST Council

    • The GST Council has the Union finance minister as the chairperson and the Union minister of state in charge of revenue or finance as a member.
    • Centre has one-third voting power, 31 states (including two Union Territories) share the remaining two-thirds of the vote.
    • The GST Council has a total of 33 members.
    • Out of a total of 33 votes, 11 belong to the Centre and 22 votes are shared by 31 states/UT, with each state/UT having a 0.709 vote.
    • Any decision of the GST Council requires a three-fourth majority or a minimum of 25 votes.
    • As the Centre has 11 votes, it requires an additional 14 votes.
    • Unlike so many statutes, Article 279A has made no provision to make the decision of the majority binding on the dissenting states.
    •  Paragraph 2.73 of the Select Committee Report on the 122nd Constitution (Amendment) Bill, 2014, noted that this voting pattern was to maintain a fine balance as, in a federal constitution, the dominance of one over the other was to be disallowed.

    Role of GST Council

    • Under Article 279A, the GST Council has to make “recommendations” on various topics including the tax rate and exemptions.
    • The Union of India argued that the “constitutional architecture” showed that Articles 246A and 279A, when read together, made the GST Council the ultimate policy-making and decision-making body for framing GST laws.
    • The GST Council was unique and incomparable to any other constitutional body and its recommendations would override the legislative power of Parliament and state legislatures.
    • Neither of them could legislate on GST issues independent of the recommendations of the GST Council.
    • The argument went further: On a combined reading of Article 279A, the provisions of the IGST and CGST Acts and the recommendations of the GST Council were transformed into legislation.
    • The Supreme Court rightly noted that several sections in the state GST laws, CGST and in IGST, cast a duty even on dissenting states to issue notifications to implement the recommendations of the GST Council.

    Observations on federalism

    • Delving into legislative history, the court ruled that a draft Article 279B, which provided for a GST Disputes Settlement Authority, was omitted because it would have effectively overridden the sovereignty of Parliament and the state legislatures, and diminished the fiscal autonomy of the states.
    • It was desirable, the Court said, to have some level of friction, some amount of state contestation, some deliberation-generating froth in our democratic system.
    • Putting to rest any controversy, the court held that the recommendations of the GST Council had only a persuasive value.
    • To regard them as binding edicts would disrupt fiscal federalism because both the Union and states were conferred equal power to legislate on GST.
    • Rule-making power bound by recommendations of GST Council: The Court held that the state governments and Parliament, while exercising their rule-making powers under the provisions of the State GST Acts, CGST & IGST Acts, are bound by the recommendations of the GST Council.
    • States can amend GST laws: But even this did not mean that all recommendations of the GST Council are binding on state legislatures or Parliament to enact primary pieces of legislation on GST.
    • In effect, states can amend their GST laws if they so choose.

    Way forward

    •  If the GST Council meets periodically as mandated and there is active participation of the states in making recommendations, no state will oppose a recommendation that has been carefully deliberated and is in the national interest.

    Conclusion

    Indeed, there is little chance of cracks developing in the GST edifice as long as the spirit of cooperative and collaborative federalism prevails.

    UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

  • Gig Workers’ Rights

    The Union Labour Ministry is organizing a program aimed at sharing information and good experiences on policies and global practices relating to gig and platform workers and their social security.

    What is the Gig Economy?

    • In a gig economy, temporary, flexible jobs are commonplace and companies tend toward hiring independent contractors and freelancers instead of full-time employees.
    • A gig economy undermines the traditional economy of full-time workers who rarely change positions and instead focus on a lifetime career. e.g Employee models of Uber, Ola, Swiggy etc
    • In this economy, tech-enabled platforms connect the consumer to the gig worker to hire services on a short-term basis.
    • Gig workers include self-employed, freelancers, independent contributors and part-time workers.

    Where does gig culture exist in Indian Economy?

    • Sectors such as media, real estate, legal, hospitality, technology-help, management, medicine, allied and education are already operating in gig culture.
    • The gig economy can benefit workers, businesses, and consumers by making work more adaptable to the needs of the moment and demand for flexible lifestyles.

    Key Drivers for Gig Economy

    • Unconventional work approach by millennials: Hectic lifestyles of employees in private sectors have created a negative perception of full-time employment among millennials.
    • Emergence of a start-up culture: The start-up ecosystem in India has been developing rapidly. For start-ups, hiring full-time employees leads to high fixed costs and therefore, contractual freelancers are hired for non-core activities.
    • MNCs are hiring contractual employees: MNCs are adopting flexi-hiring options, especially for niche projects, to reduce operational expenses after the pandemic.
    • Rise in freelancing platforms: Rise in freelancing platforms has also aided in the development of the gig economy.
    • Business Models: Gig employees work on various compensation models such as fixed-fee (decided during contract initiation), time & effort, actual unit of work delivered and quality of outcome.
    • Impact of Covid-19: Many laid-off employees are focusing on developing skills to avail freelance job opportunities and become a part of this burgeoning economy.

    Why is Gig Economy preferred by workers?

    • Profit through multiple work: One can work on freelancing as well as work full-time somewhere else.
    • Women empowerment: It is very beneficial for womenwho work on this concept when they cannot continue their work or take a break from career due to marriage or child birth.
    • Leisure and dependency: Retired peoplecan stay active after retirement as this will keep them engaged away from loneliness and depression and can earn as well on their own.
    • Flexibility and diversity to the workers: It offers flexibility when workers can work according to their convenience and schedule rather than routine like in full-time jobs.
    • Work from home: The travel costs and energy to travel to the workplace is reduced.

    Why is Gig Economy preferred by Employers?

    • Efficiency, efficacy and productivity of workers in the gig economy are much more than that of a stable full-time job.
    • More rconomical for employers-when employment givers can’t afford to hire full-time workers, they hire people for specific projects and pay them.
    • Start-up companies and entrepreneurs – who do not have big financial space – can grow only if they can leverage the services of contract employees or freelancers.
    • In a gig economy, businesses save resources in terms of benefits, office space and training.
    • Competition and efficiency among workers is improved.

    Challenges faced in Gig economy

    • No perks and benefits: There are no labour welfare emoluments like pension, gratuity, etc. for the workers.
    • Job insecurity: Gig workers may face unfair termination. They may also attain minimum wages and less paid leave.
    • No legal protection: Workers do not have the bargaining power to negotiate a fair deal with their employers.
    • Unionization of workers will be difficult.
    • Confidentiality of documents etc. of the workplace is not guaranteed
    • Urban nature: The gig economy is not accessible for people in many rural areas where internet connectivity and electricity is unavailable.

    Way Forward

    • The gig economy has been on the rise and is expected to beat the pre-pandemic estimates due the expected influx of gig workers transitioning from full-time employment.
    • While the government has taken the initial steps to ensure social security of gig workers, the ‘Code on Social Security’ needs to be fine-tuned.

     

    UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

  • Price Rise and GST

    The GST regime is due for an overhaul in tax rates levied on different products because of structural anomalies and to reduce the multiple tax slabs.

    What is GST?

    • GST launched in India on 1 July 2017 is a comprehensive indirect tax for the entire country.
    • It is charged at the time of supply and depends on the destination of consumption.
    • For instance, if a good is manufactured in state A but consumed in state B, then the revenue generated through GST collection is credited to the state of consumption (state B) and not to the state of production (state A).
    • GST, being a consumption-based tax, resulted in loss of revenue for manufacturing-heavy states.

    What are GST Slabs?

    • In India, almost 500+ services and over 1300 products fall under the 4 major GST slabs.
    • There are five broad tax rates of zero, 5%, 12%, 18% and 28%, plus a cess levied over and above the 28% on some ‘sin’ goods.
    • The GST Council periodically revises the items under each slab rate to adjust them according to industry demands and market trends.
    • The updated structure ensures that the essential items fall under lower tax brackets, while luxury products and services entail higher GST rates.
    • The 28% rate is levied on demerit goods such as tobacco products, automobiles, and aerated drinks, along with an additional GST compensation cess.

    Why rationalize GST slabs?

    • From businesses’ viewpoint, there are just too many tax rate slabs, compounded by aberrations in the duty structure through their supply chains with some inputs are taxed more than the final product.
    • These are far too many rates and do not necessarily constitute a Good and Simple Tax.
    • Multiple rate changes since the introduction of the GST regime in July 2017 have brought the effective GST rate to 11.6% from the original revenue-neutral rate of 15.5%.
    • Merging the 12% and 18% GST rates into any tax rate lower than 18% may result in revenue loss.

    Haven’t GST revenues been hitting new records?

    • Yes, they have – GST revenues have scaled fresh highs in three of the first four months of 2022, going past ₹1.67 lakh crore in April.
    • But there is another key factor — the runaway pace of inflation.
    • Wholesale price inflation, which captures producers’ costs, has been over 10% for over a year and peaked at 15.1% in April.
    • Inflation faced by consumers on the ground has spiked to a near-eight year high of 7.8% in April.
    • The rise in prices was the single most important factor for higher tax inflows along with higher imports.

    Can we expect the rate reset this year?

    • Any re-arrangement of GST rates will entail some products being taxed higher, with concomitant ripple effects on prices.
    • The Centre and the States are not unmindful of the desperate need to rationalise the rate slabs and structure but we just need to get the timing right.
    • Presently inflation is the top worry.
    • With inflation, much of it imported through pricier fuels, commodities and food items, expected to hover high through the year, the GST rate reset hopes appear bleak in 2022-23.

     

    UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

  • GST collections touched a record high of Rs 1.67 lakh crore in April.

    Context

    There has been a remarkable upswing in GST collections in recent months. Collections touched a record high of Rs 1.67 lakh crore in April.

    GST

    GST Interstate Model Example

    What are the reasons for increased collection?

    • 1] Inflation: First, the sharp rise in inflation has played a significant role.
    • Notwithstanding concerns over the unevenness of the economic recovery, in nominal terms, the economy grew by 19.4 per cent in 2021-22 as per the second advance estimates.
    • Deflating GST collection suggests that a large part of the recent increase in collections is driven by rising prices.
    • 2] Higher imports: Part of the overall increase in collections can be traced to higher imports.
    • Higher buoyancy: Even if one is to exclude the revenue accruing from imports, the rise in GST collections has outstripped GDP growth, indicating higher buoyancy.
    • 3] Tightening of the rules: In order to improve compliance levels, the GST Council has been tweaking the rules to tighten the system.
    • Returns filed have gone up, while the number of non-filers and those who delay filing have fallen.
    • Alongside, the administration has also taken steps to tackle the menace of fake invoices by placing restrictions on the quantum of input tax credit that can be used to pay of tax obligations.
    • The introduction of e-invoicing has also played a role.
    • Until recently, this was being implemented for firms with a turnover of more than Rs 50 crore.
    • From April, this process has been extended to firms above Rs 20 crore.
    • The incremental gains from bringing smaller firms into its ambit, while consequential, are unlikely to be of the same order.
    • 4] Industrial activity:  The higher collections in April 2022 seem to be led by increase in industrial activity. This is borne by strong growth in collections in states such as Maharashtra, Karnataka and Odisha which house lot of industries. Relatively tepid growth in more populous states such as Bihar (-2.47 per cent), West Bengal (7.80 per cent) and Jharkhand (4.86 per cent) shows that the GST collections was not propelled by revival in private consumption.
    •  The real challenge lies in improving compliance levels across the entire spectrum of industries where inputs/raw materials are sourced largely from the informal sector.
    • 5] Changing the structure of the economy: The formalisation of firms, the growing concentration of economic power in the hands of a few, imply that for the same level of output, the tax paid will be higher.

    Suggestion

    • Increase tax rate: Around two-fifths of the taxable value (or turnover) falls under the 18 per cent slab as per research by some analysts.
    • This implies that simply merging the 12 per cent and the 18 per cent slab as some have been suggesting would lead to a revenue loss.
    • Before opting for such adjustments, the GST Council must first ascertain the potential revenue (net of cess and refunds) at varying levels of compliance, tax rates and exemptions afforded.
    • Now, as per some estimates presented to the 15th Finance Commission, with existing exemptions in place, the current tax regime should ideally yield revenues equivalent to 8.23 per cent of GDP.
    •  In another scenario, even if existing exemptions are kept in place, and if a single rate of 14 per cent is levied, then collections should rise to 8.93 per cent.

    Conclusion

    Considering the current economic situation, now may not be an opportune moment to raise taxes. But there is no getting around it. Both the Centre and the states need to work towards this.

     

  • Supreme Court’s ruling on GST deepens the churn in the tax regime

    Context

    Last week, the Supreme Court ruled that the decisions taken by the GST Council are merely recommendations with “persuasive value” and are not binding.

    GST as a advisory body

    • The court has rejected the Centre’s contention that the entire structure of GST would crumble if the Council’s decisions were not treated as enforceable.
    • In some ways, the verdict states the obvious.
    • Article 246-A inserted after the 122nd constitutional amendment states, “Notwithstanding anything contained in articles 246 and 254, Parliament, and, subject to clause (2), the Legislature of every state, have the power to make laws with respect to the GST imposed by the Union or by such state.”
    • Thus, the power to levy the central GST (CGST) vests with Parliament, the power to levy state GST (SGST) vests with state legislatures and Parliament has exclusive power to make laws with respect to the GST on items that are part of inter-state trade or commerce.
    •  Thus, the GST Council is only an advisory body and the actual decisions regarding model GST levies, principles of levy, apportionment of GST levied on inter-state supplies, principles relating to place of supply, exemptions and rate structure and any special provisions will have to be taken by either Parliament in the case of CGST and IGST or the states in the case of SGST.
    • In effect, decisions on the structure and operation of the tax can be made by the Centre and individual states without discussion and deliberation in the Council and both can ignore any recommendation made by the Council.
    • The judgment reiterates that the sovereign right to levy the tax still exists with the Union and state governments and it is for them to consider the recommendations of the Council.
    • The chance of having a harmonised GST and reforms in the tax regime will crucially depend upon continued negotiation and bargaining between the Union and states.
    • Intergovernmental cooperation has been kept alive to ensure a harmonised GST and unless both the Centre and the states see the gains, reforms will be hard to come by and if the Centre desires the reforms more than the states, it will have to ensure a “buy in” from the states to agree for the reform.

    Implications of the judgement

    • Given that the GST Council has been declared as only an advisory body with a persuasive value, what happens to the dream of having a harmonised one nation, one tax, if a state or a group of states decides to deviate?
    • But the judgment paves the way for more intensive bargaining and negotiations, placing states on an equal footing with the Centre in taking decisions on the structure and operations of the tax.
    • At present, decisions get approved in the GST Council when passed by a majority of three-fourths of the weighted votes of the members present and voting, with the Centre having one-third weight and individual states (and UTs) having an equal share of the remaining two-thirds weight.
    • However, in the past, all decisions in the Council have been taken by consensus (except in the case of determining the rate on lotteries), and the Supreme Court decision reinforces this convention.
    • The immediate impact of this will be bargaining by states for extending the period of compensation for the loss of revenue.
    •  As the five-year period of compensation gets over at the end of June, this decision will now help the states to bargain hard for the extension.

    Way forward

    •  Though the period of collecting compensation cess has been extended till March 2026 to meet the interest and repayment requirements of the funds borrowed from the RBI to meet the compensation requirements, the lasting solution lies in increasing the revenue productivity of the tax by pruning the list of exempted items, rationalising the rates and taking administrative measures.
    • These reforms will require strengthening the cooperative spirit.

    Conclusion

    This has come at a time when reforms have to be set in motion and hopefully, the Court’s decision will strengthen the cooperative spirit in reforming the domestic consumption tax system in the country.

    UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

  • States have equal powers to make GST-related Laws: SC

    The Supreme Court has held that Union and State legislatures have equal, simultaneous and unique powers to make laws on Goods and Services Tax (GST) and the recommendations of the GST Council are not binding on them.

    What is the case?

    • The apex court’s decision came while confirming a Gujarat High Court ruling that the Centre cannot levy Integrated Goods and Services Tax (IGST) on ocean freight from Indian importers.

    Key takeaways of the Judgment

    • The recommendations of the GST Council are the product of a collaborative dialogue involving the Union and the States.
    • They are recommendatory in nature. They only have a persuasive value.
    • To regard them as binding would disrupt fiscal federalism when both the Union and the States are conferred equal power to legislate on GST.

    Basis of the Judgment

    • The court emphasised that Article 246A of the Constitution gives the States power to make laws with respect to GST.
    • It treats the Union and the States as “equal units”.
    • It confers a simultaneous power (on Union and States) for enacting laws on GST.
    • Article 279A, in constituting the GST Council, envisions that neither the Centre nor the States are actually dependent on the other.

    What are the articles added/modified to the Constitution by the GST Act?

    (1) Article 246A: Special Provision for GST

    • This Article was newly inserted to give power to the Parliament and the respective State/Union Legislatures to make laws on GST respectively imposed by each of them.
    • However, the Parliament of India is given the exclusive power to make laws with respect to inter-state supplies.
    • The IGST Act deals with inter-state supplies. Thus, the power to make laws under the IGST Act will rest exclusively with the Parliament.
    • Further, the article excludes the following products from the scope of GST until a date recommended by the GST Council:
    1. Petroleum Crude
    2. High-Speed Diesel
    3. Motor Spirit
    4. Natural Gas
    5. Aviation Turbine Fuel

    (2) Article 269A: Levy and Collection of GST for Inter-State Supply

    • While Article 246A gives the Parliament the exclusive power to make laws with respect to inter-state supplies.
    • The manner of distribution of revenue from such supplies between the Centre and the State is covered in Article 269A.
    • It allows the GST Council to frame rules in this regard. Import of goods or services will also be called as inter-state supplies.
    • This gives the Central Government the power to levy IGST on import transactions.
    • Import of goods was subject to Countervailing Duty (CVD) in the earlier scheme of taxation.
    • IGST levy helps a taxpayer to avail the credit of IGST paid on import along the supply chain, which was not possible before.

    (3) Article 279A: GST Council

    • This Article gives power to the President to constitute a joint forum of the Centre and States called the GST Council.
    • The GST Council is an apex member committee to modify, reconcile or to procure any law or regulation based on the context of GST in India.

    (4) Article 286: Restrictions on Tax Imposition

    • This was an existing article which restricted states from passing any law that allowed them to collect tax on sale or purchase of goods either outside the state or in the case of import transactions.
    • It was further amended to restrict the passing of any laws in case of services too.
    • Further, the term ‘supply’ replaces ‘sale or purchase’.

    (5) Article 366: Addition of Important definitions

    Article 366 was an existing article amended to include the following definitions:

    1. GST means the tax on supply of goods, services or both. It is important to note that the supply of alcoholic liquor for human consumption is excluded from the purview of GST.
    2. Services refer to anything other than goods.
    3. State includes Union Territory with legislature.

    Back2Basics: GST Council

    • The GST Council is a federal body that aims to bring together states and the Centre on a common platform for the nationwide rollout of the indirect tax reform.
    • It is an apex member committee to modify, reconcile or to procure any law or regulation based on the context of goods and services tax in India.
    • The GST Council dictates tax rate, tax exemption, the due date of forms, tax laws, and tax deadlines, keeping in mind special rates and provisions for some states.
    • The predominant responsibility of the GST Council is to ensure to have one uniform tax rate for goods and services across the nation.

    How is the GST Council structured?

    • The GST is governed by the GST Council. Article 279 (1) of the amended Indian Constitution states that the GST Council has to be constituted by the President within 60 days of the commencement of the Article 279A.
    • According to the article, the GST Council will be a joint forum for the Centre and the States. It consists of the following members:
    1. The Union Finance Minister will be the Chairperson
    2. As a member, the Union Minister of State will be in charge of Revenue of Finance
    3. The Minister in charge of finance or taxation or any other Minister nominated by each State government, as members.

    Terms of reference

    • Article 279A (4) specifies that the Council will make recommendations to the Union and the States on the important issues related to GST, such as the goods and services will be subject or exempted from the Goods and Services Tax.
    • They lay down GST laws, principles that govern the following:
    1. Place of Supply
    2. Threshold limits
    3. GST rates on goods and services
    4. Special rates for raising additional resources during a natural calamity or disaster
    5. Special GST rates for certain States

     

    UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

  • India’s Total Factor Productivity (TFP)

    India’s total factor productivity (TFP) growth has seen a moderate decline compared to the global experience, though it remains above that of emerging markets and developing economies, according to a recent report.

    What is Total factor productivity (TFP)?

    • Productivity levels measure the relationship between total products or output, and inputs or factors of production employed.
    • Labour productivity is a measure of total output divided by the units of labour employed in the process of production.
    • However, TFP is a measure of total output divided by a weighted average of inputs; i.e., labour and capital.
    • Improvements in TFP bring down production costs, raise output levels, and lead to a higher gross domestic product.
    • While total productivity measures all-inclusive productivity, TFP is a measure of production efficiency.

    How has India fared thus far?

    • A recent Reserve Bank of India (RBI) report points to a moderate decline in TFP growth compared to the global experience.
    • TFP growth rate for India during the 2010-2019 period was approximately 2.2%, as against -0.3% for emerging markets and developing economies.
    • During the pandemic, the TFP for India declined by 2.9% in 2020 and marginally improved by 0.1% in 2021.
    • In 2022, TFP growth rate is projected to increase to 2%.
    • As per estimates, TFP growth contributed to 30% of India’s GDP growth during 2010-2018.
    • It was largely driven by public administration, quality education and social works.

    What has been the TFP trend across the world?

    • Global productivity growth has witnessed a prolonged slowdown since 2010, with the deceleration sharper in emerging and developing economies.
    • This is ascribed to a weakening investment climate, and lower employment growth levels in developed economies, among others.
    • TFP growth for the world economy was 0.7% in 2021 and may shrink by 0.5% in 2022.

    What are the ways to improve TFP?

    • India’s initiatives around skill development and the new education policy are steps in the right direction, since they focus on boosting manpower employability.
    • Quality education, better healthcare, nurturing of innovation, introduction of efficient technology and processes in domestic companies and reduction in misallocation of resources can help improve TFP levels.
    • Though the country’s ranking in the Global Innovation Index, 2021 has improved to 46, it still has some distance to go.

    How can the industry improve productivity?

    • Improved TFP minimizes per-unit cost facilitating the horizontal expansion of consumption demand, thereby improving the standard of living.
    • Employers have fortunately started acknowledging the fact that manpower is an essential component in profit earnings.
    • Today, the focus has shifted to retaining talent, which is limited in supply.
    • This positive transformation seen after the pandemic needs to be further extended.

     

    UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

  • Explained: Repo Rate in India

    Earlier this month, the RBI, in a surprise move decided unanimously to raise the “policy repo rate by 40 basis points to 4.40%, with immediate effect”.

    What is the Repo Rate?

    • The repo rate is one of several direct and indirect instruments that are used by the RBI for implementing monetary policy.
    • Specifically, the RBI defines the repo rate as the fixed interest rate at which it provides overnight liquidity to banks against the collateral of government and other approved securities under the liquidity adjustment facility (LAF).
    • In other words, when banks have short-term requirements for funds, they can place government securities that they hold with the central bank and borrow money against these securities at the repo rate.
    • Since this is the rate of interest that the RBI charges commercial banks such as SBI and ICICI Bank when it lends them money, it serves as a key benchmark for the lenders to in turn price the loans they offer to their borrowers.

    Why is the repo rate such a crucial monetary tool?

    • According to Investopedia, when government central banks repurchase securities from commercial lenders, they do so at a discounted rate that is known as the repo rate.
    • The repo rate system allows central banks to control the money supply within economies by increasing or decreasing the availability of funds.

    How does the repo rate work?

    • Besides the direct loan pricing relationship, the repo rate also functions as a monetary tool by helping to regulate the availability of liquidity or funds in the banking system.
    • For instance, when the repo rate is decreased, banks may find an incentive to sell securities back to the government in return for cash.
    • This increases the money supply available to the general economy.
    • Conversely, when the repo rate is increased, lenders would end up thinking twice before borrowing from the central bank at the repo window thus, reducing the availability of money supply in the economy.
    • Since inflation is caused by more money chasing the same quantity of goods and services available in an economy, central banks tend to target regulation of money supply as a means to slow inflation.

    What impact can a repo rate change have on inflation?

    • Inflation can broadly be: mainly demand driven price gains, or a result of supply side factors.
    • This in turn push up the costs of inputs used by producers of goods and providers of services.
    • It is thus spurring inflation, or most often caused by a combination of both demand and supply side pressures.
    • Changes to the repo rate to influence interest rates and the availability of money supply primarily work only on the demand side.
    • It makes credit more expensive and savings more attractive and therefore dissuading consumption.
    • However, they do little to address the supply side factors, be it the high price of commodities such as crude oil or metals or imported food items such as edible oils.

     

    Try this PYQ:

    Q.If the RBI decides to adopt an expansionist monetary policy, which of the following would it not do?

    1. Cut and optimize the Statutory Liquidity Ratio
    2. Increase the Marginal Standing Facility Rate
    3. Cut the Bank Rate and Repo Rate

    Select the correct answer using the code given below:

    (a) 1 and 2 only

    (b) 2 only

    (c) 1 and 3 only

    (d) 1, 2 and 3

     

    [wpdiscuz-feedback id=”dqr429v2pr” question=”Please leave a feedback on this” opened=”1″]Post your answers here.[/wpdiscuz-feedback]

     

     

    UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

  • Brace for higher interest rates

    Context

    Inflation has now remained above the RBI’s upper tolerance limit of 6 per cent for four months in a row.

    Broad based inflation

    • The second-order impact of higher fuel prices is also visible as inflation in transport and communication surged to nearly 11 per cent, from 8 per cent in the previous month.
    • The latest data also indicates that inflation is becoming broad-based. 
    • With demand rebounding, the pass-through of higher input costs is also gaining momentum.
    • Considering that demand for goods recovered faster than services, goods producers passed on input costs to consumers.
    • But as services recover, there will be greater pass-through of prices to consumers in the coming months.
    • While there may be a slight moderation, inflation is expected to remain above the RBI’s threshold of 6 per cent in the coming months.
    • The Ukraine conflict continues to impact markets for foodgrains and vegetable oils.
    • Rising fertiliser prices are likely to push up farmers’ production costs, leading to high food prices.
    • While the government has extended price support through higher subsidies, if this will be enough to cool prices needs to be seen.

    Inflation targeting by the RBI

    • With sticky crude oil prices and continuing supply-side disruptions amplified by the Covid-induced lockdowns in China, the RBI has rightly reverted its focus on inflation targeting.
    • This is needed as central banks around the world are pursuing tight monetary policies to counter inflation.
    • The US Fed followed its 25 basis points hike by another 50 basis points rise in May.
    • These will be followed by hikes of similar magnitude in the coming months.
    • In its April policy, the RBI announced the withdrawal of excess liquidity but did not raise the policy rate.
    • Rate hikes by RBI: The RBI is now likely to respond with aggressive rate hikes to prevent the price spiral from getting entrenched.
    • The continued strength of the dollar index and sharp rupee depreciation in the last few days could impose further pressure on prices through higher imported inflation.
    • Withdrawal of liquidity support: In addition to calibrated rate hikes, the RBI needs to fast-track the withdrawal of the ultra-accommodative liquidity support provided during the pandemic.

    Implications

    • Discretionary spending: Rising inflation will cut back discretionary spending and adversely impact consumption that had only just started picking up.
    • Recession concerns: There are concerns about a recession in advanced economies as rising prices have started manifesting in a decline in purchasing power and a fall in consumer sentiments.
    • The demand destruction could trigger a moderation in prices.
    • Base metals prices have eased from the peak seen in the last few months.

    Conclusion

    Monetary policy support needs to be accompanied by fiscal support measures. The policy response will have to be tailored to the evolving geopolitical situation and the paths of commodity and food prices while balancing the imperatives of fiscal consolidation.

    UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)

  • Monetary policy alone won’t bring down inflation

    Context

    The Reserve Bank of India (RBI) last week raised both policy rates and cut back liquidity in a surprise inter-meeting decision. The forcefulness and urgency of the policy shift have been seen as a signal of the RBI’s renewed commitment to fighting inflation via aggressive monetary tightening in the coming months.

    How do higher inflation rates slow inflation?

    • It is true that a large swathe of the global economy is in the throes of runaway inflation and that in many of these economies tightening monetary and fiscal policies is the right response.
    • Initial conditions: But initial conditions matter as do the specific drivers of inflation.
    •  There are typically three ways in which higher inflation rate slows inflation.

    1] Lowering inflationary expectations

    • Suppose one believes that because a central bank has not tightened enough, future inflation will be higher.
    • In that case, the obvious response is to bring forward future consumption and investment to the present, thereby adding to demand and fueling current inflation further.
    • So, in principle, the central bank by credibly committing to bringing down inflation through aggressive current actions can bring down expectations of future inflation. 
    • It won’t work in India: This is a very potent conduit of monetary transmission in developed markets, where there is a wide variety of inflation-hedging instruments, as well as in some emerging markets — Brazil, for instance —where inflation-indexation is widespread.
    • However, there is little empirical evidence that this channel works in India, even weakly.

    2] Exchange rate channel

    • Higher interest rates attract foreign capital that appreciates the currency, lowering import prices and, in turn, inflation.
    • Again, this is a powerful mechanism in Latin America and Central Europe, where bond flows — that are sensitive to interest rate differential —dominate capital movements and the import content of the consumer basket is large.
    • Will it work in India? This is not the case in India and, in any event, for this to work it would require extreme rate hikes in the country, given the anticipated aggressive tightening by the US Fed.

    3] Curbing credit growth

    • Raising both the cost of borrowing as well as its availability (for example, by increasing the cash reserve ratio) reduces credit growth, lowering demand, GDP growth and, eventually, inflation.
    • It works well in India: This is the credit transmission by which higher interest rates dampen inflation and it works well in India.
    • How much of today’s price increase is credit-driven? Even a cursory glance at bank balance sheets would suggest that credit growth is just treading water.
    • Having recovered from being negative in mid-2021, real credit growth is running just around 2 per cent.

    Comparison with inflation-monetary policy dynamics of 2010-11

    • Back then, real GDP growth was clocking over 10 per cent per quarter, nominal credit growth 20-25 per cent, and real credit growth over 10 per cent.
    • Inflation was unambiguously driven by an overheated economy and fueled by runaway credit.
    • In the event, the RBI assessed the drivers of inflation to be originating from the supply side — higher food and commodity prices — and moved at a glacial pace, such that even after 12 rate hikes inflation remained in double digits for much of that period.
    • Faced with a potential US Fed tightening in 2013, India found itself in a near-crisis situation.
    • Today things are different. Much of the inflation is driven by global food and commodity prices.
    • Despite the languishing private demand, core inflation remains high.
    •  But this has been the case for much of the last two years, strongly suggesting that the domestic supply chain disruptions in manufacturing and services, especially at the informal level, haven’t been repaired fully.
    • The reason why firms locate in the informal sector in the first place is because of lower transaction costs, so when parts of the supply chain shift to the higher-cost formal sector, it shows up as inflation during the transition before increased scale of production and efficiency bring down the cost over time.
    • None of these factors is affected much by higher lending rates. 
    • So the burden of taming inflation by tightening monetary policy will fall largely on lower credit.
    • There is clearly a case to remove the extraordinary monetary support provided during the pandemic.

    Conclusion

    The RBI had misread the drivers of inflation badly in 2010-11. Hopefully, it won’t repeat that mistake this time.

    UPSC 2023 countdown has begun! Get your personal guidance plan now! (Click here)