Economy Insight-Putting the Lid on Inflation_March 2012

8/2/2019 Economy Insight-Putting the Lid on Inflation_March 2012

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Putting the lid on inflation

March 2012

KINGA MM ARKETSF

UNCTIONBETTE

R

YEARS

CRISILInsight


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CRISIL Insight


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Putting the lid on inflation

A report by CRISIL Centre for Economic Research


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Analytical contacts

Dharmakirti Joshi

Vidya Mahambare

Dipti Saletore

Chief Economist [email protected]

Senior Economist [email protected]

Economist [email protected]

We would like to acknowledge the contribution of Krishnan Sivaramakrishnan,

Suresh Salunkhe, Rahul Srinivasan, Harshal Bhavsar and Rashmi Parab who

helped in preparing the report.

CRISIL Insight


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Key messages

Immediate steps to reduce and stabilise inflation at lowlevels

How and why of high and persistent inflation

n Fiscal consolidation with a focus on increasing investment spending

- Develop a credible roadmap to reduce the fiscal deficit to GDP ratio

- Reorient government spending from consumption to investment to

remove supply-side bottlenecks

n Productivity improvements in bottleneck areas

- Implement policies to improve farm productivity

- Step up efforts at skill development in sectors that face acute skill

shortages- Devise mechanisms to link wages to productivity in the public sector

and in government safety-net programs such as the Mahatma Gandhi

National Rural Employment Guarantee Scheme (MGNREGS)

n Reduce shocks from sudden changes in administered prices of petroleum

fuels, by aligning them to global prices.

n The Indian economy appears caught in a high-inflation trap. Per-year WPI

(wholesale price index) and CPI (consumer price index) inflation rose to 6.9

per cent and 9.0 per cent over April 2006 to January 2012, from 4.7 per cent

and 4.1 per cent in the preceding five years. No matter how you measure it,

inflation has been high over the past six years.

n Adverse shocks from shortfall of food articles, and higher global fuel and

commodity prices triggered inflationary pressures. Persistence in inflation,

however, originated from government policies that stimulated consumption

demand but did not do enough to raise the supply potential of the economy.

n MGNREGS, sharply increased wages for rural workers from 2007. These

wage increases, which were not linked to productivity improvements, added

to inflationary pressure. This coincided with wage increases in the public

sector and in the private sector (arising from skill shortages) which

generalised inflation.

n Inflation inched further up in 2010-11; despite monetary tightening,

inflationary pressures continued in 2011-12. A series of interest rate

increases by the Reserve Bank of India (RBI) attempted to curb demand,

which the higher fiscal deficit fired by consumption-oriented spending

continued to spur. The nature and quantum of fiscal spending thus muted the

effectiveness of the monetary policy.

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CRISIL Insight

Contents Page

Key messages 1

Objective of the paper 3

Part I - How and why of high and persistent inflation 4

Inflation in India moves up 4

Fiscal policy fans inflation 5

Government policies fuel wage rise across income categories 7

Inflation-indexation of wages aggravate inflationary pressures 8

Rising demand sparks inflation in supply-deficient categories 11

Inflation becomes persistent and generalised 15

Monetary policy against backdrop of expansionary fiscal policy -

ineffective in inflation control 15

Part II - Key recommendations 17

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Objective of the paper

This paper identifies the steps that the government should take to reduceand sustain inflation at close to 5 per cent.

The recommendations draw upon an analysis of recent drivers of inflation in

India. The paper acknowledges the role of adverse supply shocks in

triggering inflationary pressures. More importantly, it emphasises the role of

government policy in accentuating the pressure on inflation.

Part I of the paper explains the recent drivers of persistent inflationary

pressures in the economy. Part II lists our key recommendations and their

underlying rationale.

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CRISIL Insight

Part I - How and why of high and persistent

inflation

Inflation in India moves up

Inflation in India has remained high and persistent in the last six years. As the

Indian economy grew at an unprecedented rate of almost 8.5 per cent during

the period, rising incomes propped the purchasing power of the population,

driving consumption demand. The surge in demand triggered inflationary

pressures, particularly in sectors where supply lagged behind. Gradually,

inflation became generalised, as public policy continued to spur growth in

consumption demand and wages.

Inflation is the increase in the average prices of a basket of goods and

services, measured by an index. There are three measures of inflation in

India: WPI, CPI, and the gross domestic product (GDP) deflator. The third

measure is the most comprehensive, as it takes into account all goods and

services produced in the economy. All three measures reveal signs of an

early pick-up in inflation in 2006-07 and persistence thereafter (Table 1).

WPI inflation consistently surpassed the RBI's comfort threshold of 5 per cent

in 51 of the 70 months between April 2006 and January 2012. It averaged 6.6

per cent over 2006-07 to 2010-11, rising from 4.7 per cent during the previous

five years. CPI inflation, over the same reference period, rose to 9.0 per cent

from 4.1 per cent, and inflation measured by the GDP deflator climbed to 7.4

per cent from 3.9 per cent. During April 2011- January 2012, CPI and WPI

inflation averaged 8.8 per cent and 9.1 per cent; inflation measured by the

GDP deflator averaged 8.2 per cent in 2011-12. Regardless of how you

measure it, inflation in India has become high and persistent (Table 1).

Note: Inflation 5% = red.

*: Data for WPI and CPI is April to January 2011-12.

1. The three measures of inflation vary in coverage. CPI includes some services and assigns higher weight to food prices, whereas

WPI assigns higher weight to manufactured products. Inflation measured by the GDP deflator covers all goods and services in the

economy.

2. WPI inflation dropped sharply in 2009-10, as fuel and commodity prices - the significant component of the index - collapsed

following the Lehman crisis.

Source: Ministry of Industry, Ministry of Labour, Central Statistical Organisation, CRISIL Research

Table 1: Persistence in inflation

Measures of inflation 2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12*

WPI based 3.6 3.4 5.5 6.5 4.4 6.6 4.7 8.1 3.9 9.6 9.1

CPI based 4.3 4.1 3.8 3.9 4.2 6.8 6.2 9.1 12.4 10.4 8.8

GDP deflator-based 3.0 3.8 3.4 5.5 4.1 6.4 6.0 8.1 7.3 9.9 8.2

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The past six years, since 2006-07 were punctuated with a series of adverse

supply shocks. The shocks arose from a shortfall in food-grain and non food-

grain commodities (vegetables, fruits, protein-based foods - pulses, milk,eggs, meat and fish). Sharp increases in international prices of fuels and

commodity too were a trigger. Persistence in inflation, however, did not arise

from supply shocks. Although supply shocks can trigger sudden and sharp

inflationary pressures, the pressures diminish when supplies revive.

Persistence in inflation stemmed, instead, from government policies that

stimulated consumption demand by increasing wages and salaries but did

not do enough to remove supply-side bottlenecks. Under fiscal policies that

boosted consumption, the supply shocks had a more lasting effect,

reinforcing inflationary pressures.

Inflation was generalised; all the categories of the WPI contributed to

inflationary pressures. Food inflation, however, was the most stubborn. It

averaged 10.2 per cent over 2006-07 to 2010-11, and prevailed at over 15

per cent in the last two years of the period. Manufacturing inflation averaged

5.3 per cent, whereas fuel inflation averaged 10.2 per cent over the five-year

period. Although food inflation has declined significantly since December

2011, it is likely to bounce back once the impact of seasonal factors and the

effect of high base wear off.

Fiscal policy is the means by which a government adjusts spending and

taxation to influence demand and the economy's capacity to produce goods

and services. In India, an expansionary fiscal policy (through cuts in taxes,

increase in government expenditure) has boosted consumption demand in

recent years.

Consumption expenditure of the government increased by ` 5,300 billion

between 2004-05 and 2010-11, in comparison to an increase of` 1,800

billion in expenditure on capital formation (Figure 1). Of the total direct

government consumption expenditure, wages and salaries accounted for

almost 50 per cent.

Since 2008-09, the government expenditure focused more on boosting

consumption demand in the short term, than on improving the economy's

productive capacity. During the global financial crisis, the government

provided fiscal stimulus in the form of indirect tax cuts and increased

expenditure. Although the tax stimulus was partially withdrawn as the

economy recovered, the increased spending to boost consumption demand

continued even after the crisis.

Fiscal policy fans inflation

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CRISIL Insight

Note: Consumption expenditure includes direct consumption expenditure and current transfers.Capital formation includes capital formation by the central government and financial assistance for

capital formation to the economy.

Source: Ministry of Finance and CRISIL Research

The rapid growth in consumption expenditure drove up total government

expenditure, increasing the fiscal deficit. Fiscal-deficit-to-GDP ratio

averaged 5.8 per cent in the post-crisis period (2008-09 to 2010-11),

compared to the initial target of 3.0 per cent set by the Fiscal Responsibility

and Budgetary Management Act (FRBM). In 2011-12 we expect the fiscal

deficit to slip to 5.5 per cent of GDP vis--vis a budget target of 4.6 per cent

(Figure 2).

The higher fiscal deficit and inadequate focus on expanding productive

capacity laid the breeding ground for inflation.

0

2,000

4,000

6,000

8,000

10,000

2004 -05 2005 -06 2006 -07 2007- 08 2008 -09 2009 -10 2010 -11

`billion Consumption expenditure Capital formation

Figure 1: Central Government expenditure on consumption and capital formation

Note: *CRISIL Research estimates

Source: Budget documents

4.04.1

3.5

2.7

6.06.4

5.15.5

2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12*

Fiscal Defit to GDP, %Figure 2: Building fiscal stress

Fiscal deficit/GDP, %

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Government policies fuel wage rise across income categories

The sharp increase in wages which was near simultaneous across income

groups in urban and rural India since 2004-05 (Box 1) boosted consumptiondemand. Urban and rural wages rose by 12.0-14.0 per cent over 2004-05 to

2009-10, compared to an increase of 7.0 per cent in the previous five-year

period. Increases in income were especially sharp after 2007-08 (Figure 3).

After the implementation of MGNREGS, rural wage growth gained

momentum. Since 2007-08, rural wages rose faster than the inflation rate, as

indicated by the sharp rise in real wages (Figure 4).

Source: National Sample Survey Organisation (NSSO)

Note: Nominal wages have been de flated by CPI for agricultural wokers

Source: NSSO

Figure 3: Near-simultaneous increase in wages across income groups

4.3 3.81.4

3.3

7.3

1.7

6.7

11.0

24.2

29.9

19.217.3

Rural casual Urban casual Rural Regular Urban Regular

Average annualgrowth nominal,%

yoy

1999-00 to 2004-05 2004 -05 to 2007-08 2007-08 to 2009 -10

Figure 4: Increase in rural wages

1.3 1.8

8.8

13.7

Regular Casual

Rural

Average annual

growth real,% yoy2004-05 to 2007-08 2007-08 to 2009-10

The rise in urban wages was an outcome of three factors: first, the supply of

skilled labour did not increase in line with demand; second, theth

implementation of the 6 Pay Commission recommendations increased

public sector wages; and lastly, rising demand for corporate- and household-

support services drove up wages of urban casual workers almost twofold.

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CRISIL Insight

Such sharp wage increases, which more than compensated for inflation, had

no explicit link to productivity improvement. Wage growth without productivity

improvements is a recipe for inflation.

The wages of a large section of workers in the economy rise in line with

inflation. Wages in the public sector are linked to inflation. In February 2011,

the government also linked wages under the MGNREGS to inflation. As

MGNREGS - wages have become the benchmark floor for rural wages,

wages of other rural workers too increase along with inflation.

The linkage between wages and inflation through MGNREGS will spread a

wage-price spiral across sections of the economy. As the wage-price spiral

threatens to fuel growth in consumption demand across the economy, it is

critical to link wage increases to productivity, to augment supply in line with

rising demand.

Inflation-indexation of wages aggravate inflationary pressures

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Box 1: Wage increase across income categories

n Incomes in rural India increase rapidly

The need to increase incomes of unskilled rural population became pressing for the government, given

insufficient job opportunities in rural areas, despite a period of high economic growth. Policymakers therefore

extended the social security scheme MGNREGS (initiated in February 2006) to all of rural India in 2008-09. This

scheme had two effects: first, it set the benchmark for wages of farm as well as non-farm rural workers (Figure

5); and second, it created a shortage of agricultural labour since workers were reluctant to migrate to other

states for farm employment. This shortage pushed up wages of agricultural workers further.

n Incomes of the urban salaried-class increased

- Skill shortage drove up wages of urban skilled labour.

Knowledge-based services (information technology) and high-skill manufacturing industries

(automobiles and pharmaceuticals) drove the rapid economic growth of over 8 per cent during 2003-04 to

2007-08. According to the Planning Commission (12th Plan Approach, page 16), rapid growth has been

accompanied by shortage of specific skills and increasing rates of employee turnover. As per a FICCI

survey conducted during August-September 2011, about 90 per cent of the respondents (largely from

industries engaged in high-skill manufacturing) ci ted shortage of skilled labour as a serious problem; 82

per cent of the respondents said that labour shortage was the reason for at least 10 per cent of wage

increase in their firms. Knowledge-based services recorded significant increases in wages. Average

wage-to-sales ratio in information technology rose by a sharp 39 per cent in recent years (Figure 6).

Source: NSSO

Figure 5: MGNREGA wages set a rural benchmark

59

49

8993 93

MGNREGA Public works other than

MGNREGS

Rural casual

Wages per day, `

2005 2010

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CRISIL Insight

- Public sector wages rise.

Wages of public sector employees, who account for almost a fifth of organised employment in India, rose inth

2008-09 (Figure 7) in line with the recommendations of the 6 Pay Commission. (The government revises

public sector wages every ten years.) In addition to a permanent increase in salaries, public sector

employees also received lump-sum cash payments as arrears. In real terms too, public sector wages rose

by 11.8 per cent during 2007-08 to 2010-11 compared to 1.6 per cent in the previous 4 years.

Source: Ministry of Finance

Note: The values for annual wages exclude travel allowances in 2008-09 and 2009-10

n Wages of urban casual workers rise

The increased incomes of the urban salaried-class and strong performance by the corporate sector drove up

demand for corporate- and household-support services. Wages of people providing these services therefore

rose. Data from the National Sample Survey Organisation (NSSO) show that wages of urban workers employed

in casual jobs almost doubled to `122 per day from`69 per day between 2004-05 and 2009-10.

Figure 7: Public sector wages per person

8495 97

107115 121

138

187

244

267

2000-01 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11

Annual wages in '000`

Source: CMIE Prowess Database, CRISIL Research

Figure 6: Wage pressure in information technology sector

37.0

38.0

39.0

40.0

41.0

42.0

Mar-06 Sep-06 Mar-07 Sep-07 Mar-08 Sep-08 Mar-09 Sep-09 Mar-10 Sep -10 Mar-11 Sep-11

Salary to total sales (%, 4 quarter moving avg)

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Rising demand sparks inflation in supply-deficient categories

The rapid wage growth drove up average spending by the population over

2004-05 to 2009-10, compared to the previous five years. As per data from

the NSSO surveys, the average nominal per-person expenditure rose from

3.6 per cent to 10.5 per cent per year in rural areas and from 5.3 per cent to

10.9 per cent per year in urban areas, during the reference period.

Although demand for almost all goods and services rose, an analysis of the

pattern of inflation based on GDP data reveals that price increases were the

sharpest for food items, real estate, public administration (cost of

government services) and social and personal services (healthcare and

education). These sectors are dependent on domestic policy actions

(Figure 8). Prices of consumer durables and telecom services, by contrast

sectors that face competition from imports did not rise as fast; prices of

certain consumer durables (microwave ovens, TV sets, computers and

video CD players) even declined during the period.

Note: CS refers to community and social economic services

Source: Central Statistical Organisation, CRISIL Research

Price increases in agricultural commodities food grains and non food-

grains averaged more than 11 per cent over 2006-07 to 2010-11, driving upoverall inflation. Three factors sparked the sharp increase in the prices of

agricultural commodities (Box 2): first, agricultural supply did not rise

adequately to meet the rising demand; second, minimum support prices

increased sharply; and third, global food prices rose and food imports could

not bridge the shortfall in domestic supply.

Prices of real estate, education and healthcare services too rose rapidly by

10.2 per cent between 2006-07 and 2010-11, from 4.9 per cent over the

previous five-year period. Domestic supply of these services could not keep

pace with rising demand. And, the nature of these services made the

possibility of imports remote.

Figure 8: Inflation dynamics across sectors

4.6

(7.9)

3.9

4.9

3.4

4.2

6.9

4.3

2.2

10.2

2.5

5.1

(10.2) 12.3

12.3

8.9

8.38.0

6.4

0.2

8.7

0.9

Manufacturing

Communication

Agriculture

Real Estate & Business Services

CS Services Ex Pub Admin & Def

Publ Admin & DefenceConstruction

Trade, Hotels,Trans, Storage

Banking and Insurance

Mining

Linked to

technology

and trade

Domestic-led

AdministeredElectricity, Gas and Water supply

%, yoy 2006-07 to 2010 -11 2001-02 to 2005-06

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CRISIL Insight

For utilities (electricity, cooking gas and domestic fuels, and water),

administered prices artificially suppressed inflation even as demand

pressure increased. The administered prices of utilities do not reflect theirtrue cost, with the exception of certain deregulated fuel categories, such as

petrol. Consumers therefore face less pressure to rationalise energy

consumption. Producers, given their inability to charge market-determined

prices, have to depend more on transfers from the government to

compensate for under-recoveries from consumers. The increasing subsidy

outgo on fuel adds to fiscal pressure. When the subsidy burden becomes

unsustainable, the government is forced to increase retail prices of fuels.

Such revisions can at times be sudden and sharp.

Prices of consumer durables and telecom services did not rise as fast as in

food items, despite the increased consumption of these products by middleand upper income groups. During 2005-06 to 2010-11, for instance, prices of

microwave ovens, TV sets, video CD players and computers fell by 3.3 per

cent, on an average.

An increase in supply potential kept a lid on consumer durables inflation.

Domestic capacities increased and imports rose simultaneously to meet the

rising demand for these manufacturing products. In technology-related

services such as telecom services, healthy competition arising from

openness in international trade and investment-friendly government polices

expanded supply potential and lowered prices.

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Box 2: Factors influencing agriculture price increases

The three factors that sparked the sharp rise in prices of agricultural products:

n Agricultural supply did not rise adequately to meet the rising demand.

Growth in agricultural production was volatile and, at 3.3 per cent average, fell short of the government target of 4.0

per cent over 2006-07 to 2011-12. Growth in food-grain production has lagged behind population growth for the past

20 years. Over 1990 to 2010, food-grain production grew annually by 1.6 per cent compared to an average annual

population growth of 1.9 per cent. While demand for food articles increased, per capita net availability of food grains

per day declined from 510 grams in 1991 to 439 grams in 2010. This mismatch exerted a persistent pressure on food

prices (Figure 9).

Source: Central Statistical Organisation and CRISIL Research

Figure 9: Widening demand-supply gap for food is exerting persistent pressure on prices

90.0

135.0

2005-06 2007-08 2009-10 2005-06 2007-08 2009-10

180.0

Price movement

2004-05 = 100Agriculture Manufacturing Services

90

150

210

Output movement

2011-122011-12

Stagnant productivity is the key reason for inadequate increase in farm production. For instance, in 2010-11, the per-

hectare yield in Punjab fell to 3.8 tonnes, from 4.03 tonnes over 2005-06 to 2009-10. Given the stagnant productivity,

the National Food Security Bill, 2011, which will raise demand for food-grains, is likely to become another source of

pressure on inflation.

Production of non food-grain items pulses, vegetables and fruits, milk, eggs, meat and fish could not cope with the

sudden and sharp increase in the consumption of these products. The insufficient supply led to a sharp rise in prices

of these items. While nominal household expenditure (not adjusted for inflation) on protein-rich items milk, eggs,

fish and meat products rose by a sharp 14.0 per cent per year after 2004-05, real household expenditure on these

items rose at a much less 3.8 per cent (Figure 10). The increase in nominal expenditure was thus largely an effect of

rising prices.

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CRISIL Insight

Despite an increase in vegetable and fruit production since 2004-05, the supply of these items fell short of demand. Inefficient

supply chain management adds to output and price volatility. A recent CRISIL Research report (August 2010) titled 'Retail FDI

to reduce fruit and vegetable wastages' observed that around 30 per cent of fruit and vegetable production (valued at Rs 630

billion) went waste in 2009-10 for lack of storage and transport infrastructure.

The need to increase both food-grain and non food-grain production will become stronger, if the Indian economy is to grow at

9.0 per cent per year. The Planning Commission estimates in its 12th Plan Approach paper that, to support a GDP growth of 9.0

per cent, agricultural production will have to grow by 4.0 per cent over 2012 to 2017.

n Sharp increases in minimum support price (MSP)

Increases in MSPs for food grains, especially wheat and rice, have been more substantial in recent years (Table 2). MSPsare based on a cost-plus formula the sharp rise in agricultural input costs since 2008-09 (Table 3) therefore made

increases in MSPs unavoidable and drove up the market price for food grains.

Source: Central Statistical Organisation, CRISIL Research

Figure 10: Household expenditure on milk, eggs, meat and fish

-1.0

4.0

9.0

14.0

19.0

2000 -01 2002 -03 2004 -05 2006 -07 2008 -09 2010 -11

%, yoy Nominal growth Real growth

n High global food prices

Global food prices have risen sharply by 14.1 per cent during 2007 to 2011. As per the joint study by Organisation for

Economic Co-operation and Development, and Food and Agriculture Organisation (OECD-FAO), agricultural

commodity prices are expected to remain elevated in the 2011 to 2020 decade. The rising global food inflation precludes

the option of bridging the domestic demand-supply gap in food through cheap imports.

2002-07 2007-12

Paddy 2 12

Wheat 4 13

Source: Agricoop, Ministry of Agriculture

Table 2: Average Annual percentage increase in MSP Table 3: Percentage increase in Agricultural input prices

2008-09 2009-10 2010-11

Inputs* 3 to 19 18 to 28 3 to 19

Wages 9 to 36 5 to 30 18 to 43

Note: *Inputs are fodder, diesel oil, lubricants, fertiliser, pesticides

Source: D. Subbarao, (2011) The Challenge of Food Inflation

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Inflation becomes persistent and generalised

As demand continued to rise, backed by wage increase, inflationary

pressures became widespread (Table 4). By 2010-11, inflation had risen in

almost all the components of WPI. Core inflation (non-food manufacturing),

reflecting demand-side pressure, started rising from 2006-07, and

accelerated after a transient decline in 2009-10.

Monetary policy against backdrop of expansionary fiscal

policy ineffective in inflation control

The key goal of monetary policy is to maintain demand at a level that keeps

inflation low and stable. For India, the objective of monetary policy is to keep

inflation at 5.0 per cent in the near term and eventually move towards 3.0 per

cent. This objective has been belied as WPI inflation has averaged 6.6 per

cent since 2006-07, and above 9.0 per cent in 2010-11 and 2011-12.

A series of interest rate increases by the Reserve Bank of India (RBI)

attempted to curb demand (Figure 11), which the higher fiscal deficit fired by

consumption-oriented spending continued to spur. The nature and quantum

of fiscal spending thus muted the effectiveness of the monetary policy.

Table 4: How inflation became generalised

WPI Inflation 3.6 3.4 5.5 6.5 4.4 6.6 4.7 8.1 3.9 9.6 9.1

Food (primary + processed) 2.0 3.0 4.1 3.5 5.4 9.6 7.1 9.1 15.2 15.8 7.3

Fuel 9.3 5.5 6.4 10.1 13.6 6.6 0.1 11.7 -1.7 12.3 13.7

Non-food manufacturing 2.2 2.2 5.0 6.5 2.6 5.7 5.0 5.7 0.2 6.1 7.6

Note: Inflation 5% = red. *: Data is from April to January 2011-12

Source: Ministry of Industry and CRISIL Research

Source: RBI

Figure 11: Monetary policy actions

3.0

5.0

7.0

9.0

11.0

%

Feb -10 May-10 Aug -10 Nov-10 Feb -11 May-11 Aug -11 Nov-11 Feb -12

Marginal Standing Facility Rate: 9.50

Reverse Repo Rate:

7.50

Repo Rate: 8.50

2001-02 2002-03 2003-04 2004-05 2005-06 2006-07 2007-08 2008-09 2009-10 2010-11 2011-12*

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CRISIL Insight

Inflation can fall below 5.0 per cent temporarily if supply shocks recede - if, for

instance, seasonal factors suddenly increase the supply of agricultural

products or international oil prices plunge. To stabilise inflation at less than

5.0 per cent, however, fiscal restraint and measures that enhance the

economy's productive capacity will be required. It will also be critical to link

wage growth across income classes to productivity improvements. Such an

alignment will ensure that demand in the economy, fuelled by income rise,

does not race ahead of supply.

Since monetary policy is forward looking, accurate forecast of inflation is

critical for inflation management. Sudden and sharp increases in

administered fuel prices, for instance, throw inflation forecast out of gear.

Our analysis finds that government policy has played a critical role in

accentuating inflationary pressures. In the next part of this report, we

therefore recommend changes in the policy that would enable the RBI to

reduce and stabilise inflation in India at around 5 per cent.

Concluding remarks

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Part II Key recommendations

This section outlines the three most critical recommendations for assistingthe RBI's efforts to sustain inflation at less than 5.0 per cent.

There is an urgent need to reduce the fiscal deficit-to-GDP ratio to a pre-

defined target and restore fiscal discipline. The government should

announce credible targets for deficit reduction in the Union Budget 2012-13,

and lay out a plan to achieve the targets. The reduction in fiscal deficit will curb

demand pressure on inflation.

The composition of government expenditure needs to lay greater emphasis

on increasing the productive capacity of the economy, through increased

investments in agriculture, education and infrastructure. To create fiscal

space to invest in these critical areas, the government will have to reduce

subsidies.

The subsidy bill has increased in the past few years, and currently accounts

for 12.0-13.0 per cent of the total expenditure. Fertiliser and oil subsidy bills

account to 54.0 per cent of total subsidy. CRISIL Research estimates that for

2011-12, fertiliser and oil subsidy bills could balloon to at least Rs 1,500

billion, twice the budgeted target. The sharp increases in subsidies would

narrow the fiscal leeway. Food subsidy is likely to increase if the government

introduces the Food Security Bill next year. An appropriate fiscal policy that

financially supports efforts to improve agricultural supply potential therefore

becomes critical.

The fiscal policy will also have to focus on increasing the availability of skilled

labour, and developing infrastructure which will enhance the growth potential

of the economy over the medium term and stabilise inflation within 5.0 per

cent.

Increasing agriculture productivity will be the surest way to taming food

inflation. Stepping up farm yields will need better irrigation, technology and

infrastructure, all of which will hinge on the government's ability to provide

fiscal policy support.

Fiscal consolidation with a focus on increasing investment

spending

Develop a credible roadmap to reduce fiscal deficit-to-GDP ratio

Reorient government spending from consumption to investment to remove

supply-side bottlenecks

Productivity improvements in bottleneck areas

Implement policies to improve farm productivity

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Step up efforts to accelerate skill development in sectors where acute skill

shortages are driving up wages.

Devise mechanisms to link wages to productivity

Reduce shocks from sudden changes in administered prices of

petroleum fuels

Wage increases in the knowledge-based services sector stem from a

shortage of skilled labour. Fast-track reforms in education that can alleviate

the skill shortage will be the key to rationalise wage growth in this sector.

Wage growth that enables people to cope with rising inflation is a desirable

policy outcome. It is, however, critical to design policies that align wage

growth with improvements in quality, productivity and capacity creation.

- Redesign social sector schemes to enhance farm productivity

Tighter monitoring of projects under the MGNREGS will ensure that

farm productivity improves. Currently, even though the scheme focuseson improving irrigation and rural water supply, ineffective

implementation of the scheme has fetched sub-optimal results.

According to the Planning Commission (12th Plan Approach paper,

page 5) with better project design under MGNREGS implementation,

leakages could be greatly reduced; and the assets so created could

make a larger contribution towards increase in land productivity.

The MGNREGS needs to be transformed into more than an

employment guarantee scheme. Coverage under the scheme should

be restricted to 3-5 years per individual; and the scheme, during this

period, should give the beneficiary incentives to improve farmproductivity or develop skills. This would increase the base of skilled

people and reduce burden on the exchequer.

Rural people who do not own farms can under skill development

programmes gain access to basic training for low-skilled manufacturing

jobs or jobs allied to farming. Vocational training can reduce the rural

population's dependence on agricultural income and on schemes such

as the MGNREGS. It will also enable the rural population to take up

work in relatively low-skilled manufacturing industries, which the

recently announced National Manufacturing Policy aims to create.

- Link a portion of public sector wages to performance

Linking a part of public sector wages to performance, a standard

practice in the private sector, will ensure that productivity gains

accompany wage increases.

Accurate forecasts of inflation are the key to inflation control since an

increase in the interest rate affects prices with a substantial lag. Inflation

forecasts can become more accurate if the government reduces the surprise

CRISIL Insight

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element in administered price changes.

Aligning international and domestic prices of petroleum fuels will reduce the

surprise element in changes to administered prices. This policy action will

also reduce the subsidy burden and rationalise demand for these products.th

According to the Planning Commission (12 Plan Approach paper, page 31),

diesel, kerosene and LPG prices are currently at least 20.0, 70.0 and 50.0

per cent less than the level, if they were aligned to international prices.

Monetary policy will remain less effective in inflation control, if fiscal policy

does not focus on improving supply of key goods and services agriculture,

skilled labour and infrastructure but keeps stimulating consumption

demand.

Increasing agricultural productivity will require the policy to foster a

supportive environment of better irrigation, better technology and

infrastructure. Linking wages to productivity will be critical for managing

demand pressures.

Increasing productivity will enable the economy to control inflation and enjoy

higher growth. Else, the economy could lapse again into a phase of lower

growth.

Concluding remarks

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Economy Insight-Putting the Lid on Inflation_March 2012

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