The key issue facing India is to sustain high growth with low inflation, and dealing with its Current Account Deficit (CAD).
In this context, if supply-side policies successfully reduce costs and inflation, macroeconomic policy can sufficiently stimulate growth.
What is the concern?
Indian output is below its potential as large numbers enter the labour force.
Bottlenecks in specific sectors limit the production and exports and so there is unutilised labour capacity.
The demand remains greater than what the country can produce domestically.
So India is still running a current account deficit (CAD) in the balance of payments i.e. value of the goods and services of imports exceeds that of exports.
How did China deal with a similar situation?
China too was a large economy with surplus labour.
Under-valuation of its currency aided an expansion in production of traded goods and of exports.
This, in turn, absorbed a large portion of the underemployed labour.
The challenge in depreciation (to increase exports) is that it would raise the import bill and inflation.
But in populous countries where food has a large share in the consumption basket, low relative food prices would ensure sustained low-inflation growth.
So a big advantage for China was that it took this approach (devaluation) in growth in 1978 with reforms that raised agricultural productivity.
Major intermediate commodity imports, such as oil, also contribute to inflation.
But again China started its reforms process with a very low share of oil imports.
China used to export oil but became a net oil importer in 1993.
By 2006 it imported 47% of its consumption, and by 2013 became the largest oil importing country.
But by then its exports had grown enough to finance imports without substantially reducing its current account surplus.
What are the challenges for India?
Challenges of both, increase in import bill and rise in inflation, remain for India.
Moreover, India is dependent on primary energy imports and is the third largest oil importer.
In India's case, only limiting the depreciation (rather than going for it) would help contain inflation.
This is because of India’s dependence on commodity imports. In other words, devaluation is disadvantageous given the need for high imports.
So better utilisation of resources and expansion of capacity in export sectors may eliminate CAD without having to reduce aggregate demand.
What are the other factors driving CAD?
Savings pattern - A CAD also implies that investment exceeds domestic savings.
Financial savings largely fund investments involving goods that are tradeable, while physical savings are invested more in non-traded goods, such as in real estate.
In recent years, overall savings-GDP ratio has fallen to about 30 as growth slowed.
However, it is fall in household physical savings that is driving this, as household financial savings have recovered from a low of 8% in 2011-12.
Savings of non-financial corporations that are held in financial assets have risen.
Estimates of physical savings in the household sector are identical to those of investment in the unorganised sector.
So, in effect, if organised sector investment exceeds financial savings, it will have to be financed by foreign savings i.e. by running a CAD.
Thus better financial intermediation of domestic savings also reduces the CAD and dependence on volatile foreign capital inflows.
Constraints in agriculture have been a major factor limiting India’s growth.
E.g. high food inflation triggered macroeconomic tightening and reduced growth after 2011
A large number of subsidies and price distortions were not able to adequately improve food production.
How does the future look?
By 2018 India seems to have entered a period of structural agricultural surpluses.
World political economy also seems to be working to keep oil prices in the $60-70 range, which suits both oil importing and exporting countries.
Moreover, with changes in oil prices, India’s oil intensity (the ratio of oil consumed per unit of GDP) has been falling since 2005, which all indicate the removal of constraints.
However, specific competitive sectors must be encouraged for the export expansion required to cover the oil import bill which remains large.
What lies ahead for India?
Supply side policies - A constant or mildly appreciating real exchange rate has to be accompanied by focused sectoral and general supply-side measures to improve exports.
Supply-side measures focus on building capacity to participate in higher growth and on reducing costs.
India's support to traded goods sectors needs to be delivered in ways that do not distort prices.
[India in 2017 crossed the WTO threshold of per capita incomes of $1000 in 2017 that allows exemptions for industry specific subsidies. Click here to know more]
Targeted and limited direct benefit transfers to farmers, along with measures to improve productivity and marketing are all steps in the right direction.
The government, in consultation with exporters, should shift to supporting policies which can specially benefit textiles and other export intensive sectors.
These include export infrastructure, logistics, skilling, technology development and ease of doing business.
Demand side policies - In a populous country with underemployed labour, sectoral bottlenecks and price shocks can cause inflation even without aggregate excess demand.
So in Indian context, as long as supply-side measures improve exports and reduce costs, macroeconomic policies have space to stimulate growth and absorb under-employed labour.
