The near doubling of food prices to 11.2 percent in the course of last year's fourth quarter is enough to convey the picture of hardship these rising prices are causing in a country where, according to World Bank estimates, more than two-thirds of the population lives on less than $2 per day. In a report published last October, another U.N. agency (Economic and Social Commission for Asia and the Pacific - ESCAP) reckons that rising food prices have kept eight million Indians from getting out of poverty.
Complex Nature of India's Inflation
But the saddest part is what India's Prime Minister Manmohan Singh and his Minister of Commerce and Industry Anand Sharma say about the country's food problems: 40 percent of fruit and vegetables rot before they get to market as a result of transportation bottlenecks.
Deficient infrastructure and an estimated 10 percent shortfall of energy supply are indicative of structural (supply side) rigidities in India's product markets. They also show why tight monetary policies – in the absence of measures to remove or attenuate these obstacles – will do a lot of damage to economic growth, without any major and lasting progress toward price stability.
Here is an example. When India initiated its latest round of credit tightening in March 2010, the wholesale price inflation (the government's inflation gauge) was 10.4 percent. Nearly three years later, in December of last year, the same inflation measure was down to only 7.18 percent, reaching, and even exceeding, 8 percent as recently as last August and September. Not much progress indeed, but rising credit costs have almost halved the economy's growth rate between the first quarter of 2010 and the third quarter of 2012.
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That is a huge problem for a country whose prime minister – a highly trained economist, and the architect of India's rapid economic development since the early 1990s – estimated a few years ago that a sustained economic growth of 10 percent was needed to reduce poverty. The U.N. International Labor Organization also thinks that a growth rate of 10 percent is required to increase India's employment by 1 percent. Apparently considering that a 10 percent growth rate was an overly ambitious policy target, Delhi scaled it back last year to 8 percent - the government's major policy objective over the next five years.
Focus on Infrastructure and Market Opening
How realistic is that objective? If it is true, as the central bank says, that the potential growth rate of Indian economy is now down to 7 percent (from 8.5 percent estimated before the 2008 financial crisis), then it is clear that destabilizing inflation pressures would put a sustained 8 percent growth over a five year period out of bounds.
Could India raise its noninflationary growth potential? Yes, it could. Given the growing labor force, India could get back to a higher growth path if it managed to open up its economy and relieve its current infrastructure and energy constraints.
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Some efforts in that direction are already under way. As in the past, market opening measures will be slow and difficult because they are part of a complex social and political process, but the announced $1 trillion of infrastructure investments from 2012 to 2017 in roads, ports, airports and urban transport look quite impressive. If implemented as planned, these investments could increase India's potential growth rate.
I also believe that measures to improve farm production would be an excellent complement to infrastructure modernization. Increasing India's food and water security would help inflation management and would also alleviate problems of poverty and malnutrition. Some 60 percent of India's population lives off the land, and the farm sector accounts for about 17 percent of the economy.
Closing India's Savings-Investment Gap
Mr. Singh is warning that large infrastructure investments will "mean higher imports" and a widening trade deficit, an indication of India's serious shortage of domestic savings. Last year, for example, India had to import foreign savings well in excess of 4 percent of its GDP to finance the current account deficit.
Defending recently his plans to open up the country to foreign capital, and to fast-track approvals of investments from abroad, Mr. Singh rightly argued that "foreign direct investments are perhaps the best source of external financing" to close India's savings-investment gap.
The problem is that India's record in attracting stable long-term capital inflows is not good. In the first seven months of the current fiscal year (ending in March), inbound foreign direct investment declined 42 percent from the year earlier to $14.8 billion. In the previous fiscal year (2011), these investments fell 24 percent. India, therefore, financed most of its trade deficits by volatile portfolio investment inflows, reflecting trading bets that the economy would soon be back on a path of accelerating growth.
That composition of the capital account is likely to continue, because it remains to be seen whether, and how much, the new measures authorizing foreign direct investments in retailing and aviation will help reverse the decline in stable capital inflows.