OVERHEATING

The inflation problem continues to fox economists and unsettle ordinary Indians. However, the
metaphorical man on the street seems to have had a better sense about the soaring arc of prices than
the men and women with econometric models.

A year ago, the overwhelming consensus among Indian policymakers and private sector economists was
that inflation would begin to decline to more reasonable levels in the quarters ahead. For example, the
Reserve Bank of India (RBI) had said in April 2010 that inflation would be at 5.5% by the end of the
fiscal year. Meanwhile, the 4,000 urban households that the central bank surveys each quarter to assess
their inflation expectations were more pessimistic. They had indicated in December 2009 that inflation
would be in double digits in the first three months of 2011.

Also Read | Niranjan Rajadhyaksha’s previous columns

The latest inflation numbers for February show that the man on the street was closer to the correct
estimate than the economists. Prices continue to surge. Inflation hovers around double digits. The
revised inflation number for January is 9.4% and the first estimate for February is 8.98%.

One explanation why households have got a better handle on the trajectory of inflation than the experts
is that information distributed in a complex system such as an economy is better captured by a large
group of people than a single model: the wisdom of the crowds. A less Hayekian explanation is that the
man on the street was just plain lucky, a factor that has a greater role to play in the prediction game
than most participants would accept.

It is the third possibility that is the most worrying. The wide gap between official inflation forecasts and
the expectations of ordinary citizens could be an indication of a serious problem—the lack of institutional
credibility. In short, common wage earners and consumers discount the guidance given by the finance
ministry and RBI on inflation. And they have diminishing confidence in the ability of these authorities to
control prices.

To be sure, the entire blame for the surge in inflation cannot be laid at the doors of the government and
the central bank. There is a structural element in the inflation trend, as higher incomes have raised
demand for fruit, meat, vegetables and milk. Some inflation has also been imported, as global oil and
commodity prices have shot up thanks to the strong economic recovery in emerging markets and loose
monetary policies in most Western economies. But domestic cyclical factors are undoubtedly a big part
of the story as well.

Higher global commodity prices are already pushing up input costs for most companies. High inflation
expectations could fuel demands for higher wages as well. Whether these two factors have an effect on
final prices depends on the ability of Indian companies to pass on higher costs to consumers. The
International Monetary Fund said this month that the output gap has closed; companies are operating
close to full capacity. The ability to pass on higher costs to consumers is usually strong at such points in
the business cycle, since there is little excess capacity to ramp up production.

The usual short-term response to an outbreak of high inflation is by cooling demand. RBI will have to
raise interest rates far more aggressively than it has till now. The government has already announced a
fairly ambitious plan to cut the fiscal deficit. Higher interest rates will weigh down on private demand
and less red ink in the national budget will keep government demand under control. Both strategies will
mean that some economic growth will have to be sacrificed. The closest we have had to an official
recognition of this hard fact is when Montek Singh Ahluwalia, deputy chairman of the Planning
Commission, said after the release of the new inflation data on Friday, that the economy is unlikely to
grow at 9% this fiscal.
However, as this column has pointed out earlier, demand management can work only in the short term.
Further, it will involve sacrificing some growth. The more sustainable response will have to come from
the supply side, through more investments and higher production capacity in farm and factory. I fail to
see how such supply side effects can kick in without policy clarity and more economic reforms.

A final point: the Economic Survey released by the finance ministry in February used simple calculations
to show that the Indian economy is quite capable of growing at 9% a year. India has an investment rate
of around 36% of gross domestic product. India requires four units of capital to produce one extra unit
output.

But what the finance ministry left unsaid was: 9% growth at what inflation rate? The recent past
reiterates an old truth. The Indian economy cannot grow at over 8% for more than a few quarters
without overheating.

Niranjan Rajadhyaksha is executive editor of Mint. Your comments are welcome at

India and Brazil

New Delhi: Emerging economies such as India and Brazil are showing signs of overheating, the
International Monetary Fund (IMF) indicated on Wednesday.

“Among some major emerging economies, capacity constraints are beginning to boost prices: Brazil, for
example, has experienced gradual increases in inflation pressure, while India has seen a sharp rise in
inflation,” the IMF said in its latest world economic outlook report.

Also See | Worrying signs (Graphic)

India’s wholesale price inflation stood at 8.5% in August, while food inflation has been in double digits
for more than a year.

Planning Commission deputy chairman Montek Singh Ahluwalia recently denied that the economy is
overheating—which happens when the country’s productive capacity is unable to keep pace with growing
demand, leading to high levels of inflation.

Reserve Bank of India (RBI) deputy governor Subir Gokarn said on Tuesday that inflation is well above
the comfort zone and is a cause of concern. RBI’s medium term inflation target is 4-4.5%.

IMF’s senior resident representative in India, Sanjaya Panth, said the inflationary situation in India is
complex, driven by both supply and demand factors. “While food supply shocks have transmitted to core
inflation quite rapidly, demand pressure has also become an important factor to explain the situation,”
he said.

In its outlook, IMF retained the growth projection for India’s gross domestic product (GDP) at factor
costs at 8.8% for the fiscal year to 31 March 2011. It raised the projection for the economy based on
market price to 9.7% from its July projection of 9.4% for calendar 2010.

GDP at market prices measures output at the prices that consumers and firms pay for goods and
services, while GDP at factor costs is the same output valued at producers’ prices. The difference
between the two consists of indirect taxes and subsidies.
Finance minister Pranab Mukherjee’s expectation that the country will grow at 8.75% in the current
fiscal year is based on GDP at factor costs.

For fiscal 2011-12, IMF expects growth to slow to 8.1% calculated on factor costs. Based on market
prices, growth is projected to grow at 8.4% in calendar 2011.

Asked why the Fund expects the economy to grow at a slower rate in next fiscal, Panth said its growth
projection of 8.8% for the current fiscal is over a rather lower base, as the economy grew at only 7.4%
in 2009-10 due to the economic slowdown.

“Following the bounce back from the crisis, growth is expected to resume broadly along the potential
growth rate next year, which could of course increase in the medium term,” he added.

The Asian Development Bank (ADB) recently said India’s economy will grow faster in 2011-12 than in
the current fiscal on robust consumer demand and private investment, even as China and most other
Asian economies slow down.

In its revised Asian development outlook, ADB said the Indian economy will grow at 8.5% in 2010-11
and 8.7% in 2011-12. Finance minister Mukherjee expects India’s economy to return to the trend
growth rate of 9% in 2011-12.

“Our growth projections are based on what is happening so far. To achieve a higher rate of growth, India
needs to unlock bottlenecks in the economy, including specially by investing in infrastructure,” Panth
said.

The IMF said industrial production and retail sales have been powering growth in India and China. “A
massive fiscal stimulus and credit expansion has boosted domestic demand in China. In India, low
reliance on exports, accommodative policies, and strong capital inflows have supported domestic activity
and growth,” the report said.

The Fund added that robust corporate profits and favourable external financing will encourage
investment. The contribution from net exports is projected to turn negative in 2011, as the strength in
investment further boosts imports.

The world economy expanded at an annual rate of about 5.25% during the first half of 2010––about
0.5% higher than in the July world economic outlook update. IMF has now increased its projection for
world output to 4.8% as compared to 4.6% in July.

Graphic by Ahmed Raza Khan/Mint

Is India Overheating

The surge in equity prices over the past few weeks has taken the major Indian stock indices close to
their historic highs. Real estate prices have also been soaring. Inflation seems to have peaked, but is
still very high by international standards. Is India overheating?

This column has earlier pointed out that the Indian economy shows signs of strain after a few quarters
of high growth. The disturbing tendency to overheat at a very early stage in the economic cycle is an
indication of underlying structural problems that need to be addressed with economic reforms. Barriers
to investment ensure that supply tends to lag demand. The shortage of skilled labour pushes up wage
costs faster than labour productivity. The government has few qualms about running pro-cyclical fiscal
policy, boosting domestic demand when it should not be doing so.
Also Read Niranjan Rajadhyaksha’s earlier columns

Finance minister Pranab Mukherjee made the astonishing claim in Parliament in August that high
inflation is the necessary price of high economic growth. This disingenuous claim does not hold when
you look at the numbers. China has been growing at close to double digits for more than a decade;
inflation has been either low or falling through most of these years, though there have been episodes of
asset bubbles in that country. The point is that high growth is not necessarily accompanied by high
inflation.

While prices of goods, services and assets need to be watched carefully in the coming months, India
does not seem to have entered bubble territory right now. A comparison with the middle of 2007 is
instructive. Those were the months when the signs of dangerous effervescence were most clear and the
Reserve Bank of India had to slam the brakes. There seem to be fewer signs for worry right now.

Here’s a quick recap of some important economic indicators—then and now. The Indian economy grew
by 9.7% in 2006-07 while it is likely to grow by 8.5% in the current fiscal. Inflation measured by
wholesale prices was 7.5% in April 2007, and going up; it was 8.5% in August and southbound. Money
supply was shooting up at 21.7% at the end of April 2007 while M3 growth is a more muted 15.1% in
the fortnight ended 27 August. Growth in non-food bank credit was accelerating at 28.5% at the end of
fiscal 2007 while it is currently growing at less than 20%.

In short, the Indian economy is growing at a slower pace right now, perhaps closer to its sustainable
trajectory; money supply and bank credit growth is more muted; and inflation —though still intolerably
high—seems to be coming off its recent highs. Overall monetary conditions are now in the restrictive
territory, according to a recent note by Nomura India economists Sonal Varma and Ketaki Sharma, who
use a weighted average of the real effective exchange rate and real policy rates to assess the tightness
or looseness of monetary policy. These are not signs of an economy in the midst of a credit bubble.

Judging whether stocks and real estate are in bubble territory is always a tough call, but a recent
analysis published in this newspaper on Monday shows that the percentage of market capitalization to
gross domestic product (GDP) is down from 160% in January 2008 to an estimated 104% right now,
based on an assumption of 8.5% economic growth in this fiscal year. In other words, the underlying
economy has grown faster than the market value of listed equities in these past 30 months or so.
Similarly, real estate prices seem to be at historic highs, but the ratio of housing prices to average
incomes is lower today than it was two or three years ago.

The main macroeconomic risks right now are elsewhere—the twin internal and external deficits. India
ended 2006-07 with a current account deficit of 1.1% of GDP. This year the external deficit could be
anything between 2.5% and 3% of GDP, one of the highest levels since the crisis of 1991. Government
profligacy has eaten into national savings and led to a wider current account deficit (or the gap between
domestic investment and domestic savings), which makes India heavily dependent on capital inflows at
a time when the world economy continues to be fragile.

Fiscal policy is way too loose at this juncture, and the Manmohan Singh government seems to have
blown away the windfall it received from the sale of spectrum for third-generation telecom and
broadband wireless. The government went to Parliament in August, seeking permission to spend an
extra Rs. 55,000 crore for various schemes. It seems very likely that the government will just about
meet its budgeted fiscal deficit target despite getting Rs. 1 trillion on a platter.

The major economic risks are not from an asset bubble, but from the growing fiscal and current account
deficits.
Niranjan Rajadhyaksha is managing editor of Mint. Your comments are welcome at
cafeeconomics@[Link]

Outline

What is overheating?

Signs of overheating.

Causes of overheating

o Impact of FII’s
o -Volatility of stock markets
o Appreciation of currency

Role of financial institutions

Current situation in India

 Increase of rates by RBI

Should India use counter cyclical buffer as a tool to control overheating

Note:- while explaining the causes of overheating and signs.. we can take example of China and Brazil