From UPSC perspective, the following things are important :
Prelims level : Dutch disease
Mains level : Paper 3- Inflation challenge
The Indian economy has been hit by inflationary shocks of late.
Inflation story so far
- RBI mandate: The inflation target of the Reserve Bank of India is 4 per cent, with a band of 2 per cent on either side.
- Inflation was at or above the upper threshold of 6 per cent since the beginning of this year.
- Only after inflation hit 7 per cent did the RBI raise the repo rate.
- Increase in interest rate: The RBI has raised the cost of borrowing (by 90 basis points so far), with a promise of more to come.
- Fuel taxes reduced: The central government has cut fuel taxes with alacrity, and has banned the export of certain items.
Role of monetary authorities
- Monetary authorities raise interest rates if inflation is above the preferred target, and vice versa.
- What should be the interest rate? Interest rates should rise more than inflation so the “real” interest rates rise, causing a compression in demand (and a fall in economic activity), which in turn will reduce inflation.
- The RBI embraced this idea. In 2016, an independent monetary policy committee was constituted.
Effects of global inflation
- Some part of inflation is coming from abroad is an added complication.
- Outflow of fund: There has also been a steady outflow of foreign funds from the stock market.
- Depreciation of rupee: This could cause the rupee to depreciate, in turn, raising the prices of imported goods thereby adding to the inflationary woes.
Two ways in which the Indian economy is different
1] Role of agriculture in Indian economy
- India’s non-food and non-oil components of the consumer price index CPI are about 47 per cent.
- In comparison, for the ECB, it is less than one-third of the CPI.
- Of course, the RBI has no control over international prices of food and oil, so it must squeeze less than 50 per cent of the domestic economy to lower inflation.
- The real interest rise works through demand compression.
- But the problem is on the supply side.
- Also, as compared to the RBI, the ECB would suffer a lower rise in inflation, and has a larger menu on which to apply demand compression.
2] Exchange rate and its effect on output
- Until the 1970s, the accepted wisdom was that an economy had to achieve both internal balance and external balance.
- Internal balance consisted of full employment and low inflation using monetary and fiscal policies.
- Over time, the internal balance has come to mean, from a policy perspective, low inflation, since “the market” will ensure full employment.
- External balance required a balanced current account over some horizon (“don’t get too much into foreign debt”), by using, for example, the exchange rate.
- For the OECD countries, the external balance was not a constraint any longer, since they had made their currencies fully convertible, and international capital flows were unrestricted.
- But this is not the case with India.
- If it were so, no one would be interested in discussing the country’s foreign exchange reserves, because these could be generated instantaneously by exchanging the domestic currency for foreign exchange.
India’s foreign reserves and its impact on competitiveness of Indian products
- Until 2020, India had seen massive portfolio capital inflows when OECD interest rates were low, and its current account deficits were financed by foreign reserves.
- But portfolio inflows can, and do, reverse themselves.
- FII inflows also contribute to India’s lack of competitiveness.
- The RBI bought foreign exchange (with rupees).
- But fearing this would stoke inflation, it sold government bonds, and removed the excess liquidity.
- This “sterilised intervention” saw the RBI’s foreign exchange assets going up, matched by a reduced holding of government bonds.
- Thus, India’s foreign exchange reserves were not its “own”— there were liabilities against it.
- India’s Dutch Disease: The RBI could have let the rupee appreciate or have accumulated foreign reserves.
- It chose an intermediate solution — a mix of an appreciation and accumulation of reserves.
- The appreciation caused by inflows reduced international competitiveness for Indian products.
- In effect, we had our own episode of the “Dutch Disease”.
- As the RBI raises interest rates, outflows will possibly slow down with the rupee appreciating.
- That is not good for external balance.
- It is easy to see that inflation targeting could be at odds with external balance.
If inflation does prove stubborn, and fighting inflation is all that the authorities in India worry about, we could see an external crisis.
Back2Basics: What is Dutch Disease?
- Dutch disease is an economic term for the negative consequences that can arise from a spike in the value of a nation’s currency.
- It is primarily associated with the new discovery or exploitation of a valuable natural resource and the unexpected repercussions that such a discovery can have on the overall economy of a nation.
- Symptoms include a rising currency value leading to a drop in exports and a loss of jobs to other countries.