"Government had to step up its demand"

"Government had to step up its demand"

The downturn affected the government as much as India Inc. The outgoing advisor to the Government of India details its impact and its lessons.

Different government departments would have learnt different lessons depending on the way they were affected by the downturn. Within the same department, the perspective of an economic advisor would be very different from that of an administrator and correspondingly the lessons learnt. I, as an individual economist, have learnt four main lessons during the period relevant for the Finance Ministry— January 2007 to December 2009.

There were not one but three related consecutive events that weave into this downturn. So, the first lesson was in managing multiple, diverse shocks. The first event was the surge in capital flows (mainly portfolio and direct investment inflows into the country) to 9 per cent of the gdp during 2007-08, much of it in January-March 2008. Inflows had fluctuated, since they were allowed in 1991, with the peaks steadily rising—1 per cent, 3 per cent, 5 per cent and 7 per cent of GDP. So the lesson was in handling fast and large inflows.

An unprecedented forex surge had learning for exchange rate and interest rate management.
The spike in global commodity prices again showed the need to modify trade management.
Global meltdown forced rapid policy reversals, making government the engine of growth.

It reinforced our broad approach of using quantitative measures (such as tightening norms for external commercial borrowings) to handle the immediate problem and supplementing them with market-based measures (e.g., auction of the right to borrow), over the medium term. {The auction mechanism takes care of the problem of "negative externalities" in financial markets ("macro-prudential" regulation). Thirty years ago when I wrote a monograph on "The Nature of Credit Markets in Developing Markets," I did not recognise how important these could be!}

The second event was the global bubble of commodity prices. It came to us in the form of global cost-push inflation (inflation caused by higher cost rather than higher demand) in March 2008. By June 2008, it had hit us severely. Analysis showed that just three sets of commodities—edible oils, steel and petroleum and their related products—had contributed to 66 per cent of the overall inflation.

This was a new type of supply-side inflation. We were familiar with the domestic agriculture-or-monsoon-related variety. Again, an old lesson was reinforced: To manage the inflation created by shortage of agriculture produce we adjust its imports and exports with quantitative decontrol and market prices through tariffs and export duties.  

Another lesson was that we need a medium-term framework for managing trade in agriculture, as the multi-layered decision-making government system, is time consuming. So we had suggested a band system in which the exports duties and import tariffs are adjusted based on relative foreign and domestic prices.

The surge in capital inflows as well as the commodity-driven cost-push inflation created challenges for monetary policy, too. In the first case, there was issue of monetisation of inflows (The Reserve Bank of India, or rbi, having to release rupees in response to incoming dollars). This impacts inflation and interest rates as it raises the quantity of rupees in the economy.  Then, both these developments affect market expectations, which in turn impacts inflation. The market was slow in correctly interpreting the nature of the two shocks which affected its expectations. As Chief Economic Advisor, I had to take the liberty to communicate the nature and policy implications of the unprecedented crisis to the markets, though the Finance Minister was conventionally the sole spokesperson.

That brings us to the third lesson which relates to the onset of global financial crisis. The crisis meant that we had to take a quick U-turn from tightening to loosening of the monetary and fiscal policy. The unexpected and unprecedented credit squeeze on non-crises countries complicated monetary management. The lesson was to strengthen emergency response processes.

Given the unprecedented decline in private demand, both direct (e.g., exports) and indirect (e.g., private investment), we were clear that this had to be offset by an increase in government demand. This could only be done by allowing the fiscal deficit to stay high in 2008-09 and keep it so during 2009-10. On the fiscal side, the government as a whole responded fairly well and faster than the markets. Yet, markets remained suspicious that this was an excuse for losing control of our fiscal situation. All our formal communications emphasised that once the impact of the global crisis has been dealt with, fiscal prudence would return.

There is (in my mind) no change in the gdp growth forecast of 6.25 -7.75 per cent in 2009-10, given in the Economic Survey (the first time ever). The latest quarterly growth numbers (7.9 per cent) are in line with the forecast. I had also said in October 2009, that I personally expected growth next year to be 8 per cent-plus and to return to the long-term growth rate of 8.5 to 9 per cent (analysed in my book Sudoku of India’s Growth) in 2011-12.

Though I do not know what individual colleagues, such as the secretaries of various departments in the Ministry of Finance have taken from this, senior officers in the Department of Economic Affairs have a broadly similar perspective. As the system for integration and institutionalisation is not very strong, some of these lessons may possibly atrophy with the normal turnover of officers. They will likely have greater longevity in the RBI, where these processes are better.

— Arvind Virmani 60, Executive Director, IMF (Chief Economic Advisor till November 2009)

(As told to Puja Mehra )