The turmoil in global financial markets and the rise in prices of crude oil, food and minerals have led the World Bank to revise its earlier forecasts of GDP growth. Revised forecasts show a slowdown in world GDP (in constant dollars of 2000) growth, from 3.7% in 2007 to 2.7% in 2008, in the US from 2.2% to 1.1%, in developing countries, from 7.8% to 6.5% and in India from 8.7% to 7%. Crude oil price more than doubled in a year to $140 a barrel at the end of June 2008. World prices of wheat, corn and other commodities have also risen substantially.
In India, the wholesale price index rose by 11.42% during the year ending June 14, 2008 as compared to 4.13% a year earlier. The rates of increase in the price index for food were more modest at 6.76% and 4.13% respectively. For India, which imports most of the crude oil it uses, the doubling in fifteen months of the price of the Indian basket of imported crude oil to $119.81 on June 3, 2008 is a major economic shock.
The coincidence of increases in commodity prices globally and in India does not imply that rises in global prices cause Indian price rises, as many in India seem to believe. The transmission of world prices to Indian prices is neither automatic nor full, because the extent of transmission is influenced by several crucial policy variables including the exchange rate of the rupee, import tariffs, export subsidies and prohibition of exports or imports. Also the Indian discussion seems to confuse changes in relative prices with inflation, which is a rise in absolute prices. Shocks to the supply of, and demand for, commodities could raise their relative prices. Unless they also affected aggregate supply and demand, and if they did, the policy (i.e., monetary and fiscal) failed to respond to both, the rate of inflation would be unaffected.
In the United States and in India, policymakers have attributed the recent rise in commodity prices in large part to a speculative bubble in futures markets. The US Congress is debating proposals for regulating futures markets and for curbing institutions such as pension funds from investing in commodities futures. The Indian government has already banned futures transactions in and also exports of some commodities. Most US economists do not share the law makers' perceptions. Certainly in India, but also in the US, there is no convincing empirical evidence, such as an inventory build up, of the contribution of speculative activity to commodity price increases. In fact, US inventories have fallen.
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By Sumit Kumar, Section Indian Economy
Posted on Mon Jul 14, 2008 at 03:03:20 AM EST
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The likely impact in the short term and long term of the turmoil in global financial and commodity markets on Indian inflation has attracted a lot of attention in India. There seems to be a consensus on a growth rate between 7-8% in 2008-09. The deputy chairman of the Planning Commission is reported to be confident that any short-term decline in growth would be made up next year and there was no need to alter the medium term target of 9% growth.
The governor of the RBI said recently that a growth rate of 8-8.5% in 2008-09 was realistic, and he was optimistic that the economy can meet the challenging task of sustaining and raising the already high growth rate. He was confident that India can safely manage the adverse shocks from the global financial markets and food prices, and oil prices would be addressed through a well managed smooth adjustment process, so that inflation would be brought in alignment with a policy target (of around 5% a year). A board of eight economists of India Today also expects a growth rate in 2008-09 between 7.5 and 8%. Most attributed the spike in inflation to global shocks, and while a majority agreed with the short-term response of the government, some felt that the government could have done more with a different mix of policies, including letting the exchange rate appreciate.
I am not entirely persuaded by the emerging consensus. The full magnitude of the shocks to the global financial markets is not yet known. A recent assessment by the IMF set the fall in asset values to be as high as $1.5 trillion. Others, though not setting losses as high, still expect it to be much higher than what has been written down thus far. Already banks are finding it difficult to replenish their capital. If the ultimate write-downs go much higher, then raising additional capital would be even more difficult.
The Bank for International Settlements in its annual report released on June 30, 2008
said that the fears of the global economy being at a tipping point toward a severe deflation and slowdown are not groundless and has urged central banks to raise key interest rates. Whether or not the global economy is at the verge of a meltdown, the interest rates will have to rise substantially, thereby ending the era of moderate global real interest and inflation rates. The firming up of real interest rates in the global markets will adversely affect the flows of portfolio investment and to a lesser extent, FDI to India. Also with policy rates rising, the quantum domestic investment could go down. With negative Indian real interest rates at present this outcome is unlikely, and improvements in the quality of investment could offset it even if it happened.
The belief that domestic saving and investment ratios, now around 35% of GDP, are unlikely to go down is a major factor in the confidence of being able to sustain a growth rate of 7.5-8% in 2008-09 and higher rates thereafter. However, the reduction in public sector deficits (and dissavings) is threatened by the recent farmloan write-offs, and the rising food and fertiliser and petroleum subsidies. Fiscal deficits could rise to as high as 9% of GDP. Private corporate savings and investment in part respond to public investment in publicly owned infrastructure. Any worsening of public savings could therefore lower aggregate savings and investment.
Food prices in India will stabilise and may even go down given last year's bumper harvest and the prospect of a normal monsoon this year. However, the prices of energy including oil are likely to remain high and perhaps rise further. Even if such rises do not raise inflation rates, they would adversely affect both the short-term and long-term prospects for sustaining rapid growth.
Finally, the well-known constraints on accelerating medium-to-long term growth are still to be addressed. These include poor infrastructure, poor educational attainments of the labour force, and slow reduction in the large share of labour force in lower productivity activities in agriculture and services, draconian labour laws and lack of permanent improvements in fiscal health. Moreover, the governance failures in many areas of the country and looming political instability are extremely worrying. Without substantial improvements in all these, sustaining an 8% annual growth, let alone raising it would be difficult.
Source: The author is the Samuel C Park Jr Professor of Economics at Yale University & Economic Times
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