Context

The monumental indirect tax reform, the Goods and Services Tax (GST), has completed five years in existence. The article analyses the impact of GST on inflation.

Background

• Before the implementation, it was said that it would be a boon to the economy in terms of higher revenue buoyancy, lower inflation, higher revenue, higher growth etc.
• During the 12 months preceding GST implementation, the Consumer Price Index (CPI) inflation was 3.66%, while it increased to 4.24% post-GST in the next 12 months.
•  A similar pattern was observed in Australia, New Zealand, and Canada.
• An Australian Competition and Consumer Commission study showed that GST initially increases inflation.

How GST can affect prices

• In theory, implementing GST should not lead to a change in overall inflation.
• The revenue-neutral rate (RNR) is calculated so that it would not cause higher inflation.
• But revenue neutrality does not mean that prices would not go up or down in the economy.
• This is because the weight of goods in the consumption basket and their contributions to indirect tax collections are not the same.
• Importantly, the effect of GST on the prices of certain goods and services depends on the structure and design of taxation.
• The RBI, in a 2017 report, showed that about half of the groups of items that GST covers are not in the CPI basket.
• So, the effect of GST on prices was expected to be small.
• Finally, prior to the GST implementation, it was expected that prices would go down because GST harmonises indirect tax rates and eliminates the cascading effect.
• Thus, whether GST has any effect depends on how different factors affect each other.

So, how can we ascertain whether GST has had an inflationary impact in India?

• Inflationary impact can be assessed by turning to statistical modeling?
• Statistical results provide us with an interesting picture of the impact of GST on price levels.
• First, we look into the overall price index (CPI).
• Here, the actual CPI growth in the study period is 4.61%, whereas the counterfactual estimate of inflation is 3.24%.
• This implies that without the GST implementation, the CPI inflation would have been 3.24%.
• This indicates that with the implementation of GST, CPI increased by 1.37 percentage points (pp).
• Second,  CPI core inflation (which strips off volatile components such as food and fuel from the headline inflation) increased by 1.04pp in the post-GST period (actual inflation was 4.57%, counterfactual inflation was 3.53%).
• Third, GST is found to have a significant positive impact on inflation of commodity groups such as paan, tobacco and intoxicants, clothing.

What explains rise in inflation post GST?

• Rise in tax rate of some goods: The rise in inflation post-GST implementation could be due to the rise in the tax rate of some goods and services, the inclusion of business activities that were not taxed earlier, or the market structure.
• The average weighted GST rate was designed to be neutral, so it might not have contributed much to the observed higher inflation.
• Coverage of business activities under GST not taxed earlier would result in higher prices since the firms would pass on the cost to the consumers.
• Market power: There is another possibility which would cause result inflation after the GST implementation.
• As Joseph Stiglitz opined, rising market power is bad for the economy as it raises economic inefficiency and inequality and lowers the economy’s resiliency.
• Further, taking advantage of market power, it is possible that most firms would have passed the taxes to end consumers.
• With the existence of market power, firms’ price includes a significant mark-up over marginal costs.
• Some results point out the possibility of profiteering in select segments after GST.
• To pre-empt this possibility, the government set up National Anti-profiteering Authority (NAA).

Way forward

•  NAA should monitor the prices of critical or essential goods and services to see the price impact of GST.
• Similarly, the Competition Commission of India should observe anti-competitive producer behaviour that hurts consumers via excessive price increases.
• These measures may ensure that producers do not take advantage of the GST.

Conclusion

Statistical results suggest that GST implementation has resulted in a decrease in inflation of food items and raised inflation of non-food items.

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Context

All emerging markets (EMs), including India, are facing outflows of foreign portfolio investment as the US Fed tightens.

Inflatioon and exchange rate

• Exchange rate as response to capital flow: Canonical inflation targeting wants exchange rates to float as the correct response to capital flows.
• Policy should respond to exchange rate fluctuations only after they affect inflation or output.
• Any interest rate defence of the exchange rate would reduce the focus on inflation.
• But most EMs intervene in foreign exchange (FX) markets in order to reduce volatility.
• A research paper by Edward F Buffie and co-authors indicate that  FX intervention greatly enhances the efficacy of inflation targeting.
• Two instruments for two targets work better than trying to do everything through the interest rate.
• Excess depreciation of currency can raise inflation.
• Other researches such as from the IMF, argues for the use of prudential capital flow management techniques and finds reserve accumulation and its use reduces risks and crises in EMs.

Policies followed by RBI to reduce volatility

• Not fully convertible: RBI’s sequenced approach to capital account convertibility, where, for example, debt inflows are only allowed as a percentage of domestic markets, saved it from the kind of interest rate volatility Indonesia experienced during the taper tantrum and is helping it now.
• More liberalisation measures can be taken when needed.
• India’s large foreign exchange reserves have allowed rupee depreciation to be lower than most other countries as the dollar strengthens.
• The cost of holding foreign exchange: There are costs of holding large reserves and of too much intervention.
• The central bank ends up supporting the US and not its own government borrowing and it sacrifices interest income.
• But holding reserves and then not using them when required is the most costly.
• Again use of multiple instruments can mitigate over-reliance on intervention.
• Much research and recent experience suggest that all available instruments should be used to moderate volatility in nominal variables.

Why increasing interest rates will be ineffective in reducing capital outflow

•  A common suggestion is to raise policy rates to maintain a historical gap with US Fed rates.
• But such an interest rate defence did not prevent outflows during the taper tantrum or in 2018 and only triggered a slowdown.
• It forgets that interest-sensitive flows are only about 8 per cent of India’s foreign liabilities.
• There have been no debt outflows in 2022 despite a narrowing interest differential.
• Equity outflows also seem to be tapering.
• Monetary tightening that dampens expectations of growth, induces more outflows as country risk-premiums rise.

Issues with less intervention

• Some want less intervention and more rupee depreciation in order to improve the current account deficit.
•  But less intervention can lead to a chaotic fall and jittery markets as we saw in 2011.
• It is best for policy to prevent over-depreciation due to global risks.
• After about 4 per cent nominal depreciation, India’s real effective exchange rate against a basket of 40 countries is approaching 100.
• That implies the real exchange rate is too depreciated since India has had relatively more structural reform and productivity growth.
• Future corrections toward equilibrium will require a rise of the rupee.
• High oil prices are a risk for India’s balance of payments, but multiple types of adjustments have the best chance of succeeding.

Why sometimes policy changes are introduced as surprise?

• Market participants want clear communication and no surprises for markets.
• Forward guidance is an important part of inflation targeting. But when markets tend to overreact and are influenced more by the US than by Indian policy, the best way to introduce a policy change may be by surprise.
• Thus markets had priced in excessive rate hikes after the US Fed began tightening.
• The steep surprise hike in Indian repo rates prevented additional rate hikes from being priced in as domestic rate-rising began.

Conclusion

Inflation targeting is an art that requires skill, attention to context and an open mind.

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Back2Basics: Real Effective Exchange Rate

• The real effective exchange rate (REER) is the weighted average of a country’s currency in relation to an index or basket of other major currencies.
• The weights are determined by comparing the relative trade balance of a country’s currency against that of each country in the index.
• An increase in a nation’s REER is an indication that its exports are becoming more expensive and its imports are becoming cheaper.
• It is losing its trade competitiveness.

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Context

There has been an uproar about the working papers of the IMF and World Bank, reporting no or low poverty for India in the pandemic year or just before that.

About the IMF paper

• The paper by Roy and Weide (2022) for the World Bank explores the possibility of using CMIE (unemployment data) in poverty calculations after correcting for the unrepresentative character of its panel data by modifying the weightages of households for aggregation.
• These adjustments carried out to remove the non-convergence of the CMIE data with other macro statistics have resulted in a poverty figure of 12 per cent.

What does the poverty index measure or attempt to capture?

• Its construction involves complex calculations — to identify a poverty basket of consumption, working out price indices for updation of the poverty line and then applying it to the income or consumption of households for determining their poverty status.
• Absence of consumption expenditure: The computation becomes far more challenging in the absence of data on consumption expenditure as is the case in India and several developing countries.
• Intending to provide inputs for policy making, researchers have evolved ingenious methods of estimating the data, using past datasets and those that have not been designed to get robust expenditure estimates.

Background of poverty line in India

• A nine-member working group set up by the Planning Commission proposed the poverty line at Rs 20 per capita per month in the early Sixties, loosely ensuring the adequacy of minimum requirements.
• Poverty line based on calorie needs: Dandekar and Rath (1970) went into detail about minimum calorie needs, based on the average consumption pattern.
• Issues with calorie based poverty line: During the Eighties and Nineties, it was realised that this linkage is getting blurred due to changes in the consumption pattern, microenvironment for living, etc.
• Sukhatme argued that the emphasis on calories and nutrition is misplaced as the absorption of nutrients depends on physical health, particularly the presence or absence of gastrointestinal diseases.
• Water and sanitation facilities were noted as important in determining the poverty line.
•  It was accepted that the state, through poverty interventions, cannot and should not try to guarantee adequate nutrition to people.
• Delinking the nutritional norms: The Tendulkar Committee formally announced delinking of nutritional norms from poverty in 2010.

Extrapolating the consumption expenditure on NSS 2011-12

• Bhalla, Virmani and Bhasin (2022) in their IMF Working Paper have developed a method of interpolation and extrapolation of the consumption expenditure of the NSS 2011-12 and building a series up to 2019-20.
• They use the growth rate of private final consumption expenditure (PFCE) but bring in the distributional changes by allowing household consumption to grow as per the nominal per capita income in each state.
• Takes into account rural-urban price difference: Rural-urban price differences are also introduced through separate poverty lines.
• The method is reasonable except that it assumes the distributions to remain unchanged both within the rural and urban segments in each state over 2014-20.
• Also, the growth rates of different commodities in the PFCE are significantly different and hence commodity-wise adjustments can be done to give higher weights to the items of consumption by the poor.
• Taking into account the role of state: The most significant contribution of the study is its bringing in the differential engagement of the state in the provisioning of the essentials to the poor into poverty calculations.
• This opens up the possibility of changes in the level of state engagement in poverty estimation, including free gas cylinders, etc.

Conclusion

People find the World Bank paper figures pegged at 12% more acceptable not because of the methodology but the magnitude. One does not know whether the poverty estimate would be a bit higher had the adjustments been carried out for a few other parameters and also at the state level.

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Context

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”.

Way forward

• 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.

Conclusion

If inflation does prove stubborn, and fighting inflation is all that the authorities in India worry about, we could see an external crisis.

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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.

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Context

Recently, the RBI has been at the receiving end for mission the inflation target.

Understanding the RBI’s rationale

• Supply side shock: Inflation has been largely the result of supply side shocks from vegetable prices, caused by crop damages due to unseasonal rains (tomato, onion and potato) in late 2019 and widespread supply-side disruptions after the outbreak of the pandemic.
• A narrow-minded focus on inflation caused by supply shocks would have constrained the MPC from supporting growth amidst the unprecedented loss of life and livelihood.
• Focusing on recovery: Therefore, it was necessary to provide a lifeline to the economy at that juncture by focusing on the recovery.
• Moreover, the wide tolerance band of 200bps +/- in the inflation targeting framework was specifically designed to accommodate such supply shocks, which provided the flexibility in the flexible targeting (FIT) framework.
• Taking into account objective of growth: In contrast to a pure inflation targeting framework (inflation nutters), the amended mandate of the RBI under FIT reads as “price stability, taking into account the objective of growth”.
• Therefore, the MPC was justified in looking through the higher inflation print during the pandemic while trying to resurrect growth.

No contradiction between Governor’s statement and MPC resolution

• Recently, the MPC highlighted inflation concerns and voted to raise the policy repo rate.
• The governor’s statement of the same day noted that the RBI will ensure an orderly completion of the government’s borrowing programme.
• Contradictory objectives: It is said that the above two actions created confusion as lowering inflation and lowering government bond yields are contradictory objectives.
• This justification is redundant as an orderly completion of the borrowing programme does not imply lowering yields.
• It basically ensures that the borrowing programme is completed seamlessly at low costs (ensured through auctions).
• Moreover, from a theoretical perspective, this is not inconsistent because controlling inflation and lowering inflation expectations bodes well for the term premia of bond yields — which moderate once expectations are anchored.
• Therefore, if inflation is reined in, the government stands to gain in terms of lower interest costs.
• Was width of corridor lost during pandemic? It is argued that  the MPC kept repo rates unchanged while the RBI changed the reverse repo rate during the pandemic, meaning that the fixed width of the corridor was lost and the MPC lost its role in setting interest rates and so, its credibility.
• This argument does not stand scrutiny.
• During the pandemic, the policy repo rate was cumulatively reduced by an unprecedented 115 bps and the interest rate on the overnight fixed-rate reverse repo was reduced cumulatively by 155 bps.
• Assymetric corridor justified in crises: This measure was not incongruous with contemporary wisdom as an asymmetric corridor has been justified, particularly during crisis times (Goodhart, 2010).
• Given that elevated inflation concerns precluded the possibility of any further repo rate cuts (cumulatively reduced by 250 basis points since February 2019), financial conditions were eased substantially by reducing the reverse repo rate, which lowered the floor rate of interest in the economy.
• Since the mandate of the MPC is to control inflation for which the policy instrument is the repo rate, the RBI had used the LAF through changes in the reverse repo rate to alter liquidity conditions.

Trade offs involved in inflation targeting for emerging economies

• Inflation-targeting countries, because of their sole focus on inflation, experience lower inflation volatility but higher output volatility.
• Higher output volatility entails a higher sacrifice ratio — the proportion of output foregone for lowering inflation.
• For an emerging economy, the costs of higher output foregone against the benefits of lower inflation must always be balanced as potential output keeps on changing given the shift of the production function.
• Developed countries, on the other hand, operate near full employment — therefore, sacrifice ratios are lower.
• As a result, smoothening inflation volatility is relatively costless for them.

Conclusion

The RBI has innovated admirably under its current stewards during the pandemic, keeping in mind the task of reinvigorating the economy. Despite the existing targeting framework, it did not get fixated on a one-point agenda, daring to look beyond the inflation print.

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Back2Basics: Liquidity corridor

• The Corridor in monetary policy of the RBI refers to the area between the reverse repo rate and the MSF rate.
• Reverse repo rate will be the lowest of the policy rates whereas Marginal Standing Facility is something like an upper ceiling with a higher rate than the repo rate.
• The MSF rate and reverse repo rate determine the corridor for the daily movement in the weighted average call money rate.

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