>How the fiscal deficit slows growth and sparks inflation: Four transmission channels (Reasons for India’s structural weakness)

Structurally higher inflation due to governmental policies
The larger fiscal deficit has fuelled inflationary pressures by widening the consumption-investment gap. Subsidized oil prices and an expansion in inclusive growth schemes (without augmenting investment) increased consumption demand to unsustainably high levels. Since the RBI responded to these demand-side inflationary pressures by tightening rates, the burden of adjustment has fallen disproportionately on investments, and more so on private investment, which is more efficient than public investment but is being crowded out by the large fiscal deficit.


In the face of rising demand and limited production, a higher minimum support price (MSP) of food crops has fuelled food inflation. Demand is increasing faster now than during 2003-07 because the middle class is approaching the income threshold, at which demand for consumer durables and higher-protein food takes off. Since nearly half of the consumer basket is comprised of food prices, this has led to an unmooring of inflation expectations. Also, the rural employment guarantee scheme, where wage hikes are linked to CPI inflation, has set a floor on rural wages and exacerbated labour shortages. In the end, this has reinforced the wage-price spiral.


Not surprisingly, average wholesale price index (WPI) inflation has increased from close to 5% during the decade prior to 2008 to 7.0-7.5% post-2008 (Figure 7), with the majority of the increase due to higher food prices (Figure 8).


In the medium term, absent an increase in investment, we doubt that WPI inflation will fall sustainably below 6%. India‟s capital stock-to-GDP ratio at 1.79 in 2010, is one of the lowest in Asia (Figure 9). Plotting capital stock-to-GDP ratios against average CPI inflation rates for 2006-10 reveals that these two variables are negatively correlated, suggesting that persistently high inflation in India appears to be well-explained by the low investment rate



Falling investment capacity
Manufacturing investment, which was the main driver of capex during 2003-07 (Figure 11), has been crowded out by the rising cost of borrowing. Infrastructure investment has been held up due to a policy logjam in acquiring land and obtaining environmental clearances. Lower investment has also hurt productivity, due to the slower adoption of new technologies. As a result, investment has fallen from a peak of 38.1% of GDP in FY08 to 35.1% in FY11 (Figure 12).


The government has flip-flopped on policies and been noncommittal on reforms. For instance, the decision in November 2011 to allow Foreign direct investment (FDI) in multi-brand retail was reversed days after being implemented. The government is also retroactively looking at taxing cross-border deals and bringing in new general anti-tax-avoidance measures, which have increased investors‟ uncertainty over the taxation regime. Despite deregulating petrol prices, oil-marketing companies have not been allowed to raise petrol prices. All of this has hurt investor sentiment and diminished the pipeline of investment projects.



The savings rate has fallen due to high inflation
A rising savings rate had been one of the foundations of India‟s expanding potential growth rate. It has made investment financing sustainable due to an ample availability of domestic funding and reduced dependence on foreign capital. This cushion has slowly eroded. The gross domestic savings rate has fallen from 36.8% of GDP in FY08 to 32.3% in FY11 (Figure 13). While the rise in the central government‟s fiscal deficit has reduced public savings, private corporate savings have also fallen due to a higher cost of production.


Overall, household saving has remained broadly unchanged, but its composition has physical savings trending up and financial savings falling, due to high inflation (Figure 14). Households have moved into physical assets as a hedge against inflation and trimmed their financial assets as the real rate of return has fallen. This shift in the composition of household saving (away from financial assets) does not bode well for sustaining growth, since it reduces the funds available to finance investment and blocks savings into non-productive assets such as gold.



A lower savings rate widens the current account deficit
India‟s current account deficit deteriorated because imports remained relatively robust while export growth slowed during the global slowdown. In our view, import demand was fuelled by four factors: 1) strong consumption demand was boosted by consumption-biased fiscal policies; 2) high inflation led to demand for gold imports4; 3) inelastic oil demand due to subsidized fuel prices (Figure 15); and 4) higher coal imports caused by delays in domestic production from slow environmental clearances (Figure 15). The national income identity suggests that a wider current account deficit reflects gross domestic saving falling much more than investment.


The need to finance a rising current account deficit has increased the economy‟s dependence on capital inflows (Figure 17). The basic balance of payments (BoP) deficit, defined as the current account plus net FDI inflows, has widened to levels last seen during the 1991 BoP crisis (Figure 18). While FX reserves provide a buffer against sudden capital outflows, their use is limited. First, domestic liquidity is already tight and USD sales by the RBI would lead to further INR liquidity shortages, which would need to be countered via open market operations and/or cash reserve ratio cuts. Second, as the RBI uses its FX reserves to defend INR, its medium-term FX vulnerability would increase as the reserve ratio worsens.



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