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Patel’s tasks on reform and inflation

by Meghnad Desai

Patel’s tasks on reform and inflation

Urjit Patel, the new governor of the Reserve Bank of India, who has taken over from Raghuram Rajan, symbolises welcome continuity at the helm of the central bank. The government deserves praise for sticking to transparency procedures for the succession, countering earlier worries that the nomination would be prone to political manipulation.

Patel moves into the top job from his previous position as a deputy governor at a generally propitious time for the Indian economy. The Indian parliament’s July to September monsoon session has turned out to be one of the most productive of recent years. With a generally low-key role up to now, Patel becomes a key player contributing to Prime Minister Narendra Modi’s ambitious plans for state reform and market strengthening.

For the time being the outlook is positive. In a notable success, the government has managed to pass the Goods and Services Tax constitutional amendment after several attempts. The tax, which simplifies and rationalises the multiple taxes on goods in transit at state level, will save time on transactions, reduce corruption and establish a national market for goods and services across India for the first time.

The government has established a monetary policy framework under which the RBI’s monetary policy committee will attempt to maintain inflation in the 4% range (with a tolerance band of 2%). During Rajan’s three-year tenure India managed to reduce consumer price inflation from 10.5% to 5.7% (see Chart 1), but the stubborn part of inflation concerns items of daily purchase – fruit, vegetables and pulses – which show unwelcome volatility due to seasonal factors. This is a supply side issue which the government needs to tackle.

Chart 1: RBI attempts to maintain 4% inflation
India inflation rate, year on year % change, 2009-16

Meghnad -chart -1 (1)

Patel’s hawkish bias makes large interest rate cuts unlikely, and most economists expect any monetary policy accommodation – regularly called for by Indian politicians distrusting the RBI’s monetary orthodoxy – to occur via increased liquidity easing rather than a significant lowering of interest rates.

Fiscal deficit target

A pay hike for government employees this year will add purchasing power to the economy, though it will make the task of maintaining the fiscal deficit target harder. However, Arun Jaitley, the finance minister, has said he is confident he will manage it.

With a doctorate in economics from Yale, earlier degrees at the London School of Economics and Oxford, and several years at the International Monetary Fund, Patel was the author of the inflation-targeting report now being implemented. His experience of the RBI’s internal functioning should stand him in good stead.

His first challenge will be to manage liquidity during a fourth quarter of non-resident investor outflows expected to total $20bn – a figure that the RBI is trying to balance without significant calls on its $367bn of foreign exchange reserves. Further clues to RBI policies will emerge in the next few weeks with the appointment of a new deputy governor taking up Patel’s previous position, as well as the three government-nominated members of the MPC.

Chart 2: Foreign exchange reserves continue to rise
India foreign exchange reserves, $bn, 2006-16

Meghnad -chart -2

The GST passage was a major milestone. As the tax alters the powers of states and the centre in respect of taxation, it required a constitutional amendment, now agreed after 15 years of attempts by governments of rival parties, in a rare display of unanimity. State legislatures will have to ratify the amendment. Legislation will be introduced in the winter session to implement the act, and it will then become part of the tax structure, hopefully by April 2017.

The GST has been a flagship priority for the Indian People’s party/New Democratic Alliance government since it took power two years ago, and the ruling party has had to learn much in respect of cross-party co-operation during this time. It has a majority in the lower house but not the upper house, where the Congress party blocked the bill. This was the reason for the delay. But a deal has been struck and the act has been passed.

Private investment is buoyant in the e-commerce sector but sluggish in the core industrial area. Nationalised banks are reducing the burden of non-performing loans on instruction from the RBI. There is consolidation in the nationalised bank sector. The State Bank of India is absorbing five smaller banks and will become the first Indian institution to enter the league table of the world’s largest 75 banks.

The longer-run task is to make the state a more efficient economic actor. India has a statist bias both in entrusting the government with many activities as provider and purchaser, and as a regulator. Governments like to create new entitlements while keeping old ones, which lowers efficiency and leads to recurring fiscal problems.

Lord (Meghnad) Desai is Emeritus Professor of Economics at the London School of Economics and Political Science and Chairman of the OMFIF Advisory Board.