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Subject: Economics

  • Power crisis in India

    Context

    The power crisis has taken us by surprise. The question in everyone’s mind is: where did we go wrong? And who slipped up?

    Responsibilities in supply chain

    • Under the Electricity Act, it is the responsibility of the Distribution Licensee/Company (Discom) to provide reliable quality and round-the-clock electricity to all consumers to meet full demand.
    • To do so, they enter into contracts with a number of generating companies in order to ensure adequate supply.
    • These Discoms work under the oversight of the State Electricity Regulatory Commissions.

    Suggestions

    1] Dealing with the challenge of demand prediction

    • Qualitative transformation in demand: With higher incomes and the consequent increase in the use of air-conditioners and other electrical appliances, the nature of electricity demand is undergoing a qualitative transformation with rising daily and seasonal peaks, and spikes on very hot or cold days.
    • While demand prediction is inherently uncertain, the questions to ask are whether Discoms have been making and updating their demand growth projections and scenarios over the medium term with adequate supply arrangements in a robust manner.
    • This needs to become central to the regulatory process.
    • Ensuring reliable supply to meet unanticipated peaks, as have occurred now, requires making supply arrangements with reserve margins that are adequate.
    • The Regulatory Commissions need to provide for such expensive peaking power arrangements in the tariffs they approve.
    • It is also time to move towards separate peaking power procurement contracts in addition to the present system of long-term thermal power contracts.

    2] Demand-based time of day rates of electricity

    • A transition to demand-based time of day rates of electricity for generators as well as consumers would help.
    • These should be brought in by the Regulatory Commissions.
    • Flattening of demand curve: Peak demand moderation and flattening of the demand curve through a change in consumer behaviour is feasible with smart meters.
    • But this would take place only with a strong price signal, a large differential in peak and off-peak rates.

    3] Subsidies and politics

    • Free supply of electricity to farmers and households up to a specified level is not a problem as long as State governments pay for it as provided in the Act, and the Regulatory Commissions do not at the same time act from a political point of view and shy away from determining cost-reflective tariffs.
    • While the problem of delayed payments by Discoms is getting highlighted and needs to be resolved with a sense of urgency, the coal supply problem is not due to this.
    • Coal India needs to create capacities to rapidly ramp up production; and the Railways need to carry larger quantities of coal when demand surges, as has happened now.
    • Imported coal and gas generated electricity: There is idle but expensive generating capacity available — about 15-20 GW of gas-based power plants which can run on imported liquefied natural gas, and 6 GW-8 GW of thermal plants which can run on imported coal.
    • Consumers who are willing to pay more could be kept free of power cuts with purchase and supply of more expensive electricity generated from imported coal and gas.
    • To improve reliability, Discoms, with the approval of the Regulatory Commissions, need to go in for bids for storage.

    Conclusion

    A lesson is that demand growth projections and supply arrangements need to become central to the regulatory process.

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  • Control inflation by acting on liquidity

    Context

    The recent action of the Reserve Bank of India (RBI) to raise the repo rate by 40 basis points and cash reserve ratio (CRR) by 50 basis points is a recognition of the serious situation with respect to inflation in our country and the resolve to tackle inflation.

    Inflation in India and role of government expenditure

    • India’s CPI inflation has been fluctuating around a high level.
    • As early as October 2020, it had hit a peak of 7.61%.
    • It had remained at a high level of over 6% since April 2020.
    • It did come down after December 2020 but has started rising significantly from January 2022.
    • On the other hand, the Wholesale Price Index (WPI) inflation had remained in double digits since April 2021. The GDP implicit price deflator-based inflation rate for 2021-22 is 9.6%.
    • Even though the RBI’s mandate is with respect to CPI inflation, policymakers cannot ignore the behaviour of other price indices.
    • After the advent of COVID-19, the major concern of policymakers all over the world was to revive demand.
    • Keynesian prescription: This was sought to be achieved by raising government expenditure.
    • Thus, the expansion in government expenditure did not immediately result in increased production in countries where the lockdown was taken seriously.
    • However, the Keynesian multiplier does not work when there are supply constraints as in developing countries.
    • That is why the multiplier operates in nominal terms rather than in real terms in such countries.
    • Something similar has happened in the present case where the supply constraint came from a non-mobility of factors of production.
    • Nevertheless, the prescription of enhanced government expenditure is still valid under the present circumstances.
    • Perhaps the increase in output could happen with a lag and also with the relaxation of restrictions.

    Role of monetary policy

    • Why lover money multiplier rate? Initially, the focus of monetary policy in India has been to keep the interest rate low and increase the availability of liquidity through various channels, some of which have been newly introduced.
    • However, the growth rate of money was below the growth rate in reserve money.
    • This is because of lower credit growth which also depends on business sentiment and investment climate.
    • Thus the money multiplier is lower than usual.
    • The Government’s borrowing programme which was larger went through smoothly, thanks to abundant liquidity.
    • Even as the economy picked up steam in 2021-22, inflation also became an issue, this is a worldwide phenomenon.
    • In India too there is a shift in monetary policy.

    Analysing the cause of inflation

    • While discussing inflation, analysts focus almost exclusively on the increases in the prices of individual commodities such as crude oil as the primary cause of inflation.
    • General price level: Supply disruptions due to domestic or external factors may explain the behaviour of individual prices but not the general price level which is what inflation is about.
    • Given a budget constraint, there will only be an adjustment of relative prices.
    • Besides the fact that any cost-push increase in one commodity may get generalised, it is the adjustment that happens at the macro level which becomes critical.
    • It is the adjustment in the macro level of liquidity that sustains inflation.

    Inflation and growth

    • The possible trade-off between inflation and growth has a long history in economic literature.
    • The Phillip’s curve has been analysed theoretically and empirically.
    • Tobin called the Phillip’s curve a ‘cruel dilemma’ because it suggested that full employment was not compatible with price stability. 
    • The critical question flowing from these discussions on trade-off is whether cost-push factors can by themselves generate inflation.
    • In the current situation, it is sometimes argued that inflation will come down, if some part of the increase in crude prices is absorbed by the government. 
    • If the additional burden borne by the government (through loss of revenue) is not offset by expenditures, the overall deficit will widen.
    • The borrowing programme will increase and additional liquidity support may be required.

    Concomitant decisions on CRR and repo rate

    • These are concomitant decisions. Central banks cannot order interest rates.
    • For a rise in the interest rate to stick, appropriate actions must be taken to contract liquidity.
    • That is what the rise in CRR will do.
    • In the absence of a rise in CRR, liquidity will have to be sucked by open market operations.

    Conclusion

    Beyond a point, inflation itself can hinder growth. Negative real rates of interest on savings are not conducive to growth. If we want to control inflation, action on liquidity is very much needed with a concomitant rise in the interest rate on deposits and loans.

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  • What is the Xiaomi Scam?

    Last week, the Enforcement Directorate had seized Rs 5551.27 crore ($725 million) from the local bank accounts of the Chinese smartphones company, Xiaomi.

    Unfolding the Xiaomi Scam

    • Xiaomi faces charges of having made illegal remittances to foreign entities by passing them off as royalty payments.
    • It is a charge that Xiaomi has been continuously facing in India.
    • The ‘royalty and licence fee’ paid by Xiaomi India were not being added to the transaction value of the goods imported by the company and its contract manufacturers.
    • By not adding “royalty and licence fee” into the transaction value, Xiaomi was evading Customs duty.

    What is the recent probe?

    • The Enforcement Directorate has seized the bank account assets from Xiaomi Technology India, under the provisions of Foreign Exchange Management Act (FEMA.
    • The company had remitted over Rs 5500 crore to foreign-based entities, including one Xiaomi group entity, in the guise of royalty payments.
    • Such huge amounts in the name of royalties were remitted on the instructions of their Chinese parent group entities.

    Xiaomi’s response

    • Xiaomi, for its part, said that it is committed to working closely with government authorities to clarify any misunderstandings.
    • It argued that the royalty payments and statements to the bank are all legit and truthful and were made for the in-licensed technologies and IPs used in our Indian version products.
    • It is a legitimate commercial arrangement for Xiaomi India to make such royalty payments.
    • But it is a typical corporate response, something on the lines that Xiaomi did on the previous occasion too.

    How has China responded?

    • China firmly support its companies in protecting their lawful rights and interests.
    • It urged India to provide a fair, just and non-discriminatory business environment for Chinese companies making investment and operating in the country.
    • It is visible that China has made a dovish statement as they usually do.
    • Xiaomi now has alleged its top executives faced threats of “physical violence” and coercion during questioning by ED.

    Indian govt on strong wicket

    • Indian governmental authorities have made it clear that the Chinese companies were not being targeted.
    • And financial misdemeanours had indeed been committed by these companies.
    • The government has also explained the various cases in details and what it has seized so far.
    • But the Chinese companies seem to be playing the victim card.

    Back2Basics: Directorate of Enforcement (ED)

    • ED is a law enforcement agency and economic intelligence agency responsible for enforcing economic laws and fighting economic crime (esp Money Laundering) in India.
    • It is part of the Department of Revenue of the Ministry of Finance.
    • It is composed of officers from the Indian Revenue Service, Indian Police Service and the Indian Administrative Service as well as promoted officers from its own cadre.
    • The total strength of the department is less than 2000 officers out of which around 70% of officials came from deputation from other organizations while ED has its own cadre, too.
    • The prime objective of the Enforcement Directorate is the enforcement of two key Acts namely:
    1. Foreign Exchange Management Act 1999 (FEMA) and
    2. Prevention of Money Laundering Act 2002 (PMLA)

     

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  • Debate over Front of Pack Labelling (FoPL) of Packaged Food

    The Food Safety and Standards Authority of India (FSSAI) is expected to issue a draft regulation for labels on front of food packets.

    What is FoPL?

    • In India, packaged food has had back-of-package (BOP) nutrient information in detail but no FoPL.
    • Counter to this, FoPL can nudge people towards healthy consumption of packaged food.
    • It can also influence purchasing habits.
    • The study endorsed the HSR format, which speaks about the proportions of salt, sugar, and fat in food that is most suited for consumers.
    • Countries such as the UK, Mexico, Chile, Peru, Hungary, and Australia have implemented FoPL systems.

    What warranted such rating in India?

    • Visual bluff: A lot of Indian consumers do not read the information available at the back of the packaged food item.
    • Burden of NCDs: Also, India has a huge burden of non-communicable diseases that contributes to around 5.87 million (60%) of all deaths in a year.
    • Healthy dietary choices: HSR will encourage people to make healthy choices and could bring a transformational change in the society.
    • Supreme Court order: A PIL seeking direction to the government to frame guidelines on HSR and impact assessment for food items and beverages was filed in the Supreme Court in June 2021.

    Which category of food item will have HSR?

    • All packaged food items or processed food will have the HSR label.
    • These will include chips, biscuits, namkeen, sweets and chocolates, meat nuggets, and cookies.
    • However, milk and its products such as chenna and ghee are EXEMPTED as per the FSSAI draft notified in 2019.

    Will there be pushback from food industry?

    • Negative warning: Some experts opposed the use of the HSR model in India, suggesting that consumers might tend to take this as an affirmation of the health benefits rather than as a negative warning of ill effects.
    • Lack of awareness: This is significant because there is lack of awareness on star ratings related to consumer products in India.
    • Impact on Sale: Certain organisations fear it might affect the sale of certain food products.

    When will the rating come into force?

    • FSSAI’s scientific panel recommends voluntary implementation of HSR format from 2023 and a transition period of four years for making it mandatory.
    • It noted that the proposed thresholds are in alignment with the models implemented in other countries and ‘WHO population nutrient intake goals recommendations’.
    • FSSAI will analyse the nutritional information in 100 mg of packaged food.
    • The food safety compliance system licensing application portal will have a module for generating certificates wherein a licensee can enter details of a product.

     

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  • What are India’s plans to avert a Wheat Crisis?

    On May 4, the government lowered its wheat production estimates by 5.7% to 105 million tonnes (MT) from the projected 111.32 MT for the crop year ending June.

    Decline in wheat production

    • India is the second largest producer of wheat in the world, with China being the top producer and Russia the third largest — Ukraine is the world’s eighth largest producer of wheat.
    • After five straight years of a bumper wheat output, India has had to revise downwards its estimated production.
    • Unprecedented heatwaves across the north, west and central parts of the country, and March and April being the hottest in over 100 years, have caused substantial loss to the yield.
    • Researchers attributed the lower estimates to “early summer” affecting the crop yields in States, especially Punjab, Haryana and Uttar Pradesh.

    Why is there a decline in govt procurement?

    • Ukrainian war: Private traders have been prompted to buy more wheat from farmers as the price of wheat at the international level has shot up due to Ukrainian war.
    • Higher prices: A large quantity of wheat was being bought by traders at a higher rate than the minimum support price (MSP).
    • Hoarding by farmers and traders: Also, farmers are holding on to some quantity of wheat, expecting higher prices for their produce in the near future.

    How will this impact the public distribution of grain?

    • Wheat procurement is undertaken by the state-owned Food Corporation of India (FCI) and other agencies at MSP to meet the requirements under the Public Distribution System (PDS).
    • Other running welfare schemes is the Pradhan Mantri Garib Kalyan Anna Yojana (PMGKAY) introduced during the pandemic.
    • The government has revised the grain allocation under PMGKAY for May to September 2022.
    • According to the new guidelines, the FCI will fill the gap left by wheat with an increased allocation of rice.
    • Pointing out that from next year, fortified rice will be distributed to the entire Public Distribution System (PDS).

    Will domestic wheat prices be hit?

    • As government wheat procurement has dipped, concerns are being raised about the stability of prices in the country.
    • The availability of grain for internal consumption, many agri-experts argue should be a priority.
    • The government has dismissed concerns about both prices and stocks, asserting that India is in a comfortable situation with the overall availability of grains.
    • India has enough stocks to meet the minimum requirement for next one year for meeting the requirement of welfare schemes.

    How is the global supply situation shaping up?

    • In order to meet the gap created by reduced Russian and Ukrainian exports, importers are turning to alternative markets.
    • Wheat-producing countries like India are looking to increase exports.

    Will farmers benefit?

    • Farmers will certainly benefit from the scenario as they are being offered a price above the MSP.
    • Amid the Russia-Ukraine crisis, new markets in countries like Israel, Egypt, Tanzania and Mozambique have opened up for India.
    • However, if private traders continue to buy above MSP, eventually that could stoke inflation.
    • More private buying of wheat will help India expand the agri-export basket to new countries, riding the current crisis situation.
    • This trade relationship will stay even when the global crisis is over, which means farmers will get about 10%-15% extra price as market prices are ruling above MSP.

    What about export plans?

    • After Egypt, Turkey has also given approval for the import of Indian wheat.
    • India has been eyeing deals with new export markets in European Union countries too.
    • Despite the crop loss and revision of the output estimate, the Centre maintained that no curbs would be placed on wheat exports and that it was facilitating traders.

     

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  • What is Direct Seeding of Rice (DSR)?

    The Punjab government recently announced Rs 1,500 incentive per acre for farmers opting for Direct Seeding of Rice (DSR), which is known for saving water.

    What is DSR technique?

    • In transplanting, farmers prepare nurseries where the paddy seeds are first sown and raised into young plants.
    • These seedlings are then uprooted and replanted 25-35 days later in the main field.
    • Paddy seedlings are transplanted on fields that are “puddled” or tilled in standing water using tractor-drawn disc harrows.
    • In DSR, there is no nursery preparation or transplantation. The seeds are instead directly drilled into the field by a tractor-powered machine.

    How much water is required to grow one kg rice?

    • Paddy is non-shelled rice that farmers grow and sell in mandis and then after milling paddy rice is prepared.
    • According to the studies, around 3,600 litres to 4,125 litres of water is required to grow one kg rice depending upon the paddy variety.
    • Long duration varieties consume more water.
    • In Punjab, 32% area is under the long duration (around 158 days) paddy varieties, and the rest comes under paddy varieties that take 120 to 140 days to grow.
    • So, on an average 3,900 to 4,000 litres water is required to grow one kg rice in the state.

    How much water is used in Punjab every year to grow rice?

    • In 2020-21, Centre procured 203 lakh tonnes of paddy from Punjab.
    • After milling, this procured paddy resulted in 135.98 lakh tonnes of rice.
    • Since studies put average water required to produce one kg rice at 4,000 litres, so in one year – based on last year’s estimate – Punjab needed 5,400 billion litres of water to produce 135 lakh tonnes rice.

    How much water can DSR help save?

    • DSR technique can help save 15% to 20% water.
    • In some cases, water saving can reach 22% to 23%.
    • With DSR, 15-18 irrigation rounds are required against 25 to 27 irrigation rounds in traditional method.
    • Since area under rice in Punjab is almost stagnant, DSR can save 810 to 1,080 billion litres water every year if entire rice crop is brought under the technique.

    Are there any other benefits of DSR tech?

    • DSR can solve labour shortage problem because as like the traditional method it does not require a paddy nursery and transplantation of 30 days old paddy nursery into the main puddled field.
    • With DSR, paddy seeds are sown directly with machine.
    • DSR offers avenues for ground water recharge as it prevent the development of hard crust just beneath the plough layer due to puddled transplanting.
    • It matures 7-10 days earlier than puddle transplanted crop, therefore giving more time for management of paddy straw.
    • Research trials indicated that yield, after DSR, are one to two quintals per acre higher than puddled transplanted rice.

    Getting optimum results

    • Experts said that with DSR technique, which is called ‘tar-wattar DSR’ (good soil moisture), farmers must sow paddy only after pre-sowing (rauni) irrigation and not in dry fields.
    • Further, the field should be laser levelled.
    • They said that spraying of herbicide must be done simultaneously along with sowing, and the first irrigation, which is done at 21 days after sowing.

    Limitations of the DSR

    • Suitability of soil is the most important factor as farmers must not sow it in the light-textured soil.
    • This technique is suitable for medium to heavy textured soils including sandy loam, loam, clay loam, and silt loam which accounts for around 80% area of the state.
    • It should not be cultivated in sandy and loamy sand as these soils suffer from severe iron deficiency, and there is higher weed problem in it.
    • Also, avoid direct seeding of rice in fields which are under crops others than rice (like cotton, maize, sugarcane) in previous years as DSR in these soils is likely to suffer more from iron deficiency and weed problems.

     

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  • India must seize the trade opportunity opening now

    Context

    Slower global growth, an adverse geopolitical environment, the shadow of recurring waves of the pandemic and prolonged supply chain issues are likely to weigh on export growth this year.

    Trade growth in 2021 and uncertainties in 2022

    • The year 2021 was a record one for trade despite the pandemic.
    • In terms of volumes, merchandise trade rose 9.8 per cent, while in dollar terms, it grew 26 per cent.
    • The value of commercial services trade was also up 15 per cent.
    • India has had a good export run in line with global trends, witnessing record goods exports of $419 billion, while touching $250 billion in services exports.
    • However, global growth forecasts have now been pared down.
    • Slower global growth, an adverse geopolitical environment, the shadow of recurring waves of the pandemic and prolonged supply chain issues are likely to weigh on export growth this year.

    Taping into opportunities

    • Ukraine and Sri Lanka are major exporters of agricultural products and the vacuum created by their limited presence in global trade will open up agricultural export opportunities for India.
    • This will not only spur overall exports but will also help to support the recovery of the agrarian economy through higher realisations.
    • Tea and wheat: As many as 25 African countries import more than one-third of their wheat from Russia and Ukraine and for 15 of them, the share exceeds 50 per cent.
    • Sri Lanka is also a major player in the global tea market and produces around 300 million kg annually.
    • Almost 98 per cent of its annual production is exported.
    • India, the second-largest producer of tea with an annual production of 900 million kg, is in a good position to exploit the opportunity and fill the gap.
    • Textile: Apart from tea and wheat, newer export opportunities have arisen for textiles.
    • Sri Lanka exports $5.42 billion worth of garments and prolonged power cuts in the island nation will hurt its production and export capacity.

    Suggestions

    • 1] Work on non-tariff barriers: One, work on non-tariff barriers for agricultural trade with a special focus on harmonising the sanitary and phytosanitary (SPS) requirements.
    • 2] Autonomy in tea sector: To support tea exports, traditional tea boards are seeking a greater role and autonomy for optimising the development, promotion, and research in the sector.
    • Quicker implementation of the proposed Tea Promotion and Development Act is of utmost importance.
    • 3] Integration with global supply chains: India must double down on its integration with global supply chains.The commerce ministry has negotiated a slew of trade deals.
    • 4] Reduce tariff rates for intermediate inputs: Tariff rates for intermediate inputs should be reduced to either zero or should be negligible for India to become an attractive location for assembly activities.
    • 5] Realignment of specialisation patterns: India must persist with the creation of an enabling ecosystem that realigns its specialisation patterns towards labour-intensive processes and product lines.
    • The labour market reforms must be taken to their logical conclusion.
    • 6] Pro-active FDI policy: A continuous and pro-active FDI policy is also critical as foreign capital and technology are key enablers for entry into global production networks even as local firms play a role as subcontractors and suppliers of intermediate inputs to MNEs.
    • 7]Power supply and logistical bottlenecks: Lastly, exports could suffer if basic issues such as availability of power and logistical bottlenecks keep rearing their ugly heads.
    • The Economic Survey 2019 had recommended that low levels of service link costs (costs related to transportation, communication, and other tasks involved in coordinating the activity etc) are prerequisites to strengthen their participation in GVCs.
    • This should not be neglected.

    Conclusion

    If India were to tap export opportunities in developed markets, it must act on the suggestions above.

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  • Let’s make GST a good and simple tax

    Context

    The GST has been a remarkable achievement and a unique experiment in cooperative federalism. In this, both the Union and the state governments gave up their tax autonomy in favour of harmonising domestic trade taxes.

    Multiple rates: A major shortcoming in the structure of GST

    •  One of the most important shortcomings in the structure of GST is multiple rates.
    • The committee headed by the Chief Economic Adviser estimated the tax rate at 15-15.5 per cent.
    • It further recommended that in keeping with growing international practice, India should strive towards a single rate in the medium-term to facilitate administrative simplicity and compliance, but in the immediate context, it should have a three-tier structure (excluding zero).
    • The structure finally adopted was to have four rates of 5, 12, 18, and 28 per cent besides zero, though almost 75 per cent of the revenues accrue from the 12 and 18 per cent slabs.
    • Why single rate structure? The reasons for adopting a single rate structure in most countries are to have a simple tax system, prevent misclassifications and litigations arising therefrom, and to avoid an inverted duty structure of taxes on inputs exceeding those on outputs requiring detailed scrutiny and refunds.
    • Why multiple rates? The main reason for rate differentiation is equity.
    • But it is argued that this is an inefficient way of targeting benefits for the poor. 
    • Although the exempted and low-rated items are consumed relatively more by the poor, in absolute terms, the consumption may be more by the rich. 

    Suggestions

    • Focus on the expenditure side: The ideal way of targeting the benefits to the poor is on the expenditure side, through targeted cash transfers to vulnerable groups and providing quality education and healthcare.
    • Of course, unprocessed food items have to be exempted for reasons of administrative difficulty, but the list should be kept small.
    • Right time to rationalise the rates: Now, in fact, is the opportune time to rationalise the rate structure.
    • The economy is in recovery mode and more importantly, GST revenues have shown reasonably high buoyancy with collections of over Rs 1 lakh crore in the last 10 months and touching a record of Rs 1.68 lakh crore in April 2022.
    • Role of e-invoicing: The revenue increase has not come about only due to the economic recovery.
    •  The more important reason seems to be that at last, the GSTN has been able to stabilise the technology platform.
    • Mandating the issue of e-invoicing for all businesses above Rs 100 crore has enabled better invoice matching and detection of fake invoices that were used to claim the input tax credit.
    • This has helped to improve tax compliance and has also enabled better enforcement.
    • With time, the GSTN should be able to enforce e-invoice requirements on all businesses above Rs 10 crore, which will cover more than 95 per cent of taxpayers.
    • Dealing with the excessive rate differentiation: The GST council is concerned about the problems arising from excessive rate differentiation and has set up a seven-member ministerial panel .
    • But it has been widely reported that the committee is thinking of increasing the lower tax rate from 5 per cent to 8 per cent and moving some essential items from the 5 per cent category to the 3 per cent slab.
    • This will be retrograde because a rate category will be added. The need of the hour is to reduce the rate categories.
    • Merge 12 and 18 per cent categories: It would be preferable to merge the 12 per cent and 18 per cent categories into a 15-16 per cent slab and move the items in the 5 per cent category to the 8 per cent slab and remove the 28 per cent category altogether. 

    Conclusion

    The merger of 12 and 18 per cent categories will result in the GST structure with two rates and as the cesses will cease after 2026 when the compensation requirement is over, it will really become a “good and simple tax”.

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  • Inflation control needs another model

    Context

    At the conclusion of the April meeting, the Monetary Policy Committee had already warned that the focus will henceforth be on inflation. Yesterday it raised the repo rate somewhat sooner than was expected by the market.

     Discourse on inflation engaged in by the western central banks

    • Inflation reflects an excess of output over its ‘natural’ level.
    • Inflation targeting refers to the policy of controlling inflation by raising the interest rate over which the central bank has control, i.e. the rate at which it lends to commercial banks, the ‘repo rate’.
    • This, it is argued, will induce firms to stay their investment plans and reduce inventories, lowering production.
    • As economy-wide output declines, becoming equal to the natural level of output, inflation will cease.
    • This story does not just legitimise a policy of output contraction for inflation but sees it as optimal.
    • The natural level of output itself is the productive counterpart of the natural level of employment, the level that obtains in a freely functioning labour market.
    • So, at the natural level of output, the economy is deemed to be at full employment.
    • Salient in the context is the fact that the natural level of output is unobservable.
    • Hence inflation as a reflection of an “overheating” economy is something that must be taken on trust.

    Inflation control in India

    • Not surprisingly for a theory based on an unobservable variable, the proposition that inflation is due to an overheating economy fares poorly when put to a statistical test for India. 
    • There is not a single demonstration of the empirical validity of the model of inflation presented in the RBI report of 2014, which recommended a move to inflation targeting.
    • On the other hand inflation in India can be explained in terms of the movement of the prices of agricultural goods and, to a lesser extent, imported oil.
    • How effective is monetary policy in controlling inflation: The implication of this finding is damaging for the claim that monetary policy can control inflation, for neither the price of agricultural goods nor that of imported oil is under the central bank’s control.
    • The only route by which monetary policy can, in principle, control inflation is by curbing the growth of non-agricultural output, which would in turn lower the growth of demand for agricultural goods.
    • As the demand for agricultural goods slows, so will inflation, but this comes at the cost of output and employment.
    • At least, this is the theory.
    • Whether this takes place in practice depends upon the extent to which changes in the repo rate are transmitted to commercial bank lending rates.

    Way forward

    • Focus on supply of agricultural goods: The implication for the policymaker that inflation is driven by agricultural goods prices, as is the case in India presently, is that the focus should be on increasing the supply of these goods.
    • Growing per capita income in India has shifted the average consumption basket towards foods rich in minerals, such as fruits and vegetables, and protein, such as milk and meat.
    • But the expansion of the supply of these foods has been lower than the growth in demand for them.
    • So a concerted drive to increase the supply of food other than rice and wheat holds the key.
    • Costly food threatens the health of the population, as people economise on their food intake, and holds back the economy, as only a small part of a household’s budget can be spent on non-agricultural goods.

    Conclusion

    Monetary policy manoeuvres, typified by the RBI’s raising of the repo rate is not an efficient solution for agricultural price-driven inflation. Any lasting inflation control would require placing agricultural production on a steady footing, with continuously rising productivity.

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  • With repo rate hike, RBI has done what’s necessary

    Context

    The RBI has decided to take the bull by the horns. It has raised the repo rate by 40 basis points and the cash reserve ratio (CRR) by 50 basis points to fight inflation.

    Why major central banks across the world are hiking rates?

    • Across the world, major central banks have of late gone on a rate hike spree, waking up to the realisation of inflationary pressures not being transitory in nature.
    • Record high inflation in the US: The US Fed has been on the offensive battling a 40-year high surge in prices.
    • It has tapered its bond purchase programme drastically while suggesting in no uncertain terms the pace of rate hikes needed to combat inflation.
    • The European Union has been slow to respond but voices are growing to correct the path at the earliest.
    • Banks like the Central Bank of Brazil or the Russian Central Bank have increased the interest rate to double digits.
    • Emerging economies have been doubly hit — the days of easy liquidity are well behind them even as their economic resources remain constrained to support an uneven proportion of population hit by pandemic.
    • Including the RBI’s decision today to push the benchmark rate to align with the current market realities, 21 countries have increased interest rates so far.

    Analysing the RBI’s decision to hike interest rates

    • To this extent, the decision by the RBI to frontload the rate hikes ahead of the Fed decision is again an attempt to stem capital outflows.
    • Accommodative policy stance; The most interesting aspect of the rate hike today is the continuation of the accommodative policy stance.
    • The CRR hike may be just an attempt to build up a war chest on the liquidity front.
    • Liquidity inflows to the financial system could be either policy induced by the central bank for example changes in reserves, open market operations etc or non-policy induced such as foreign exchange reserves, government cash balances, and currency in circulation.
    • Given that non-policy induced liquidity inflows have been recently impacted (outflows of portfolio capital) and given the huge size of the government borrowing programme, the RBI also needs to support the market through some means.
    • Impounding bank reserves through the CRR (Rs 87,000 crore) could give some space to the central bank to conduct open market purchases of bonds from banks and thus inject concomitant liquidity some time in the future if the need so arises.
    •  The CRR rate hike is thus an important tool to possibly manage G-sec yields.

    Inflation dynamics in India

    • The inflationary pressures can be attributed mainly to adverse cost-push factors, coming from supply-side shocks in food and fuel prices.
    • The RBI statement thus cites food inflation as a major source of discomfort.
    • Additionally, nominal rural wages for both agricultural and non-agricultural labourers picked up during the second half 2021-22.
    • However, such wage growth has remained soft.
    • Measures to ameliorate supply-side cost pressures would be thus critical at this juncture, especially in terms of a calibrated reduction of taxes on petrol and diesel.
    • On the policy side, however, it would mean that even after rate hikes, inflation may continue to remain high for some time.
    • The MCLR (Marginal Cost of Funds based Lending Rate) linked loans have a share of around 53 per cent in the overall loan kitty.
    • With the rise in CRR and expected future hikes in the benchmark rates, there would be an increase in MCLR due to a negative carry.

    Conclusion

    The RBI has acted prudently in responding to market forces that could impact India’s growth prospects if inflationary concerns were not addressed now. At the same time, by pledging to remain accommodative to spur, and reinvigorate growth, it has reaffirmed its commitment to being a trusted partner in the growth of the country.

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