Monday, 22 December 2014

The Power of Zero

In normal parlance achieving zero is not a happy state. Getting zero in examination assessment reports or levels of economic activity or assessing prospects of growth is held as sign of underperformance and weakness. Yet there is some cheer in the economic world for reaching the state of zero inflation. India’s wholesale inflation fell to zero in November- from 7.52 percent a year ago - lowest since July 2009.  There are multiple ways in which price indices are computed in India. The Wholesale Price Index (WPI) measures the price of a representative basket of wholesale goods. In India, this basket is composed of three groups, namely, Primary Articles, Fuel and Power and Manufactured Products. Historically, the wholesale price index (WPI) has been the main measure of inflation in India. The WPI is used by the Government to measure inflation. However, in 2013, the Reserve Bank of India adopted the Consumer Price Index (CPI) as the key measure of inflation following the recommendation of the Urjit Patel Committee. The consumer price index (CPI) undoubtedly works better than wholesale price index (WPI) in capturing market dynamics and arriving at a more realistic inflation forecast. This preferred measure of price index has also come down to 4.38 percent in November from 11.6 percent a year ago. Part of the sharp fall in both retail and wholesale inflation is due to the significant moderation in prices of food and fuel witnessed in recent weeks in addition to the favourable base effect.  There are several questions which this raises.
First, the cost and condition of accessing formal credit is influenced by inflationary trends. Contrary to expectations, the RBI in its last policy review announced two weeks ago decided to keep the interest rates unchanged at 8.0 percent which is considered as too high for encouraging new investment decisions.  Infact, the RBI has maintained a retail inflation target of 8% by January 2015 and 6% by January 2016. The Consumer Price Index inflation falling below the 6% target considerably earlier than anticipated may prompt the RBI to begin its easing cycle sooner than later. There are however doubts on the trajectory of inflationary expectations. Inflationary expectation surveys are conducted by the RBI periodically by eliciting opinion of households on their future price expectations. This influences consumer behaviour and consumption pattern. According to the latest Inflation expectation survey of the RBI, the inflationary expectations over the next three months and one year are at 14.6 and 16 percent compared to 12.9 and 15.3 percent in March 2014. Many however doubt if these findings are realistic in nature in determining interest rates. There are also apprehensions on whether the decline in prices of food or fuel is transitory in nature or sustainable. The decline in interest rate has to be sharp and steep to make a difference by signalling that the worst is over also in making investment decisions more viable.
Second, there is a broader issue of refocusing on long-pending reforms with inflation having moderated significantly.  It offers an opportunity and considerable flexibility for politically sensitive subsidy rationalisation apart from number of other economic changes. These reforms can be fast-tracked now including the distortionary regime of price controls and cross-subsidies on LPG, Kerosene and Fertiliser to mention a few. Having eliminated under-recoveries in diesel that amounted to Rs 62,837 crore in 2013-14, the government needs to target the Rs 77,000 crore-odd subsidy on cooking fuels next. It should do this by making all consumers pay the market price for LPG and kerosene, and transferring the difference directly into the bank accounts of actual beneficiaries. The latter must be carefully identified, to include only low-income or vulnerable households deserving of subsidy. The fertilizer subsidy remains a key burden on government finances which is currently estimated at Rs 70,000 crore.  There is therefore need for a rationalistic approach towards pricing of fertiliser and the most commonly used soil nutrient Urea.  Moderating Food prices offers a window of opportunity to fully decontrol sugar and reform the public distribution system to roll out the Direct benefit Transfer scheme. Similarly, prices of public utilities, including electricity, transport and rail passenger fair and freight rates can be progressively freed given the favourable circumstances. The market share of Indian Railways in total freight traffic has been falling consistently and this calls for rationalization of cross-subsidies between passenger fares and freight rates to remove distortions. This is therefore a historic opportunity to fast-track these reforms to make the economy more competitive.
Finally, moderating inflation is also an opportunity to reform the tax regime to make it more progressive and to strengthen the public finances. Moderating inflation is positive news for the government as lesser subsidy outgoes on food and petroleum products and lower costs of borrowing can improve the fiscal health of the economy. Lower input costs and interest rates can boost private investment in infrastructure projects.  With the Wholesale Price Index at zero and the Consumer Price Index at below 5% level, the Indian economy should start picking up steam. But this would largely depend on the pace of fiscal and expenditure reforms which took a back seat in the previous years.
The power of zero is a far reaching power. It is a signal of change which affords an opportunity for undertaking long-postponed reforms. Not only has Modi won a historic but the external circumstances have also turned favourable unthinkable only few months ago. Economists may view the free fall in inflation with lots of caution but this could not have come at a more opportune time for India especially with several reform issues hinged on the behaviour of headline inflation. The power of zero must therefore be fully harnessed. Coming few months will be keenly watched on whether we are able to make the most of it.