Are the stimulus measures stroking inflation or driving economy

By withdrawing the stimulus too soon, you face the risk of stalling recovery. By withdrawing it too late, you run the risk of inflation. So it's a real balancing act.

A lot of monetary accommodation was provided by the RBI in the immediate aftermath of the crisis in October 2008. Right after the collapse of Lehman Brothers, the RBI lowered interest rates, the cash reserve ratio and the statutory liquidity ratio. And it provided all sorts of refinancing facilities for various sectors of the economy, on the grounds that the crisis was such a disruptive phenomena that all these policies were required to allow credit to continue to flow.

These were all steps in the right direction. Now that the economy is stabilising and recovering quite nicely, in the normal course the RBI would have gradually withdrawn this accommodation. Currently, there is a lot of liquidity in the system. As you may be aware, there is a liquidity adjustment facility offered by the RBI where banks can park their excess liquidity. In normal times it is about Rs 40,000 crore, now it is running at about Rs 1,00,000 crore.

Banks have been given a lot of liquidity but credit demand has not picked up yet. In part this is because corporates have excess capacity and they are not putting in place big investment programmes. So the fear that the RBI has is that this excess liquidity could enter the system when demand picks up and create inflationary pressures.

So, quite apart from the food inflation, there is a case for the RBI to withdraw the monetary accommodation. It has already taken steps in that direction and my guess is that it would continue to do so in the policy review in January.

Now, food inflation is a completely different, and quite a complicated, problem. The problem is that of an increase in demand through the stimulus measures without a matching increase in supply. The drought exacerbated this situation. And sadly there are no quick-fix solutions to this problem.

Even in normal circumstances, the supply response, in terms of cropping cycles, etc, takes a few months. You can resort to imports to relieve some of the supply constraints. But India now is a very large consumer in the global market for some commodities.

If it goes to the global markets and imports large amounts of rice, wheat or sugar, it will end up driving up global commodity prices. So it's a real dilemma that the Government faces.

Unfortunately there are no easy solutions. It has to be a combination of getting more supplies into the market through the public distribution system, including imports. In the medium term the Government has to take a serious look at the supply scene and agricultural policies so that we don't have a repeat of this situation.

What we have had in India is an upward shift in demand because of the stimulus programmes. This is showing up in inflation in the first instance, but over time, I expect that to cool off to some extent. But there has been a big increase in demand, and the question is whether that demand is being met in the best way possible through the right policies.

Now that the economy is recovering well, with GDP, industrial production and exports having grown, do you think this is the right time for the Government to withdraw the stimulus package and pay more attention to the fiscal deficit and the looming inflation?

By withdrawing the stimulus too soon, you face the risk of stalling recovery. By withdrawing the stimulus too late, you run the risk of facing excess demand and inflation. So it's a real balancing act. There is enough evidence that the recovery is well under way. So the withdrawal of the monetary and fiscal stimulus should begin. The other thing to keep in mind is, like many other countries, monetary policies, especially interest rate policies, take a long time to have an impact on the economy, sometimes even 12 months down the road. So when you see signs of a pick up in economic activity and inflation, economic theory tells you that you must start adjusting in small steps, not in big steps, so that you can strike a balance between choking recovery and stoking inflation. So I think the time is right to start withdrawing the stimulus on the monetary side.

On the fiscal side, there is no doubt that the fiscal policies have helped in the recovery, and Indian policymakers deserve credit for that. But the problem is that we talk in terms of fiscal space. That is, when the times are good you are supposed to build up a buffer, so that when the times are bad you can draw it down.

If you do not build up a buffer when the times are good, you have a problem and that's essentially what has happened now. If you look at bond yields, the 10-year yield, which is where signs of a high deficit show up, has gone up a lot. This is one main reason why there should be some fiscal control. We have to wait till the next Budget to see, not only to what extent the Government wants to control the deficit but how.

India needs massive investments in infrastructure to sustain growth in the long term. Given the precarious fiscal situation, where will the Government find the money to undertake such massive investments in power, roads, ports, etc?

The Planning Commission said that during the Eleventh Plan it would like to spend $500 billion in infrastructure investments. Now, how can this be financed? When this announcement was made, the fiscal deficit was half its current size. This means that the Government is spending a lot more than what it's taking in as revenues. Looking at the public finances and private savings, you would still need foreign capital inflows to finance the planned infrastructure. On the positive side, there is a recognition that infrastructure investments need to be taken up on a war footing, and the private sector is getting into it in a big way

To finance infrastructure projects you need a well developed corporate bond market — that is, a long-term bond market because infrastructure projects are long term. You cannot get a bank, which holds deposits of 1-3 years, to finance a 10-year project.

In India, corporate bond market does not really exist and there are many reasons for that. These have been studied extensively, even by the Government through various expert committees, such as R.H. Patil, Deepak Parekh, and Raghuram Rajan. So there is no mystery about what needs to be done. For developing a corporate bond market the constraints are both on the regulatory side as well as the tax side (stamp duties, for instance). You need the government bond market to function better.

The second issue is whether the financial system is equipped to intermediate these financial resources. How does the system work to take the money from the saver and give it to the investor in an efficient and stable way? Other than these there are the regulatory issues and those relating to land acquisition. I think a beginning has to be made, a direction has to be set and some reforms on the financial sector also have to be undertaken, and then you'll see the process moving forward.

Despite the impressive growth in the manufacturing sector over the last decade, employment growth hasn't kept pace, jobless growth is one major criticism made. Your thoughts on this issue?

I have done a study, with co-authors that include Raghuram Rajan and Arvind Subramanian, in which we looked at how the Indian policy environment impacted the pattern of development.

We argued that variety of policies, including labour laws, reservations on small-scale industries (which has now mostly ended but existed for a long time), have all conspired to create a very capital intensive industrial sector, whereas being a labour abundant economy we should have been encouraging more labour-intensive industries.

Though the labour laws were put in place to protect labour, they ended up generating an industrial structure where employment was low, so the labour that was protected by the laws ended up being small in number. Most of the employment was being generated in the unorganised sector.

I also believe that we are underestimating the amount of employment that is being generated in the manufacturing sector. And this is partly because of the labour policies and partly because of the way we collect our statistics. Nowadays you hear of textile workers, who were laid off earlier, being rehired.

When I talked to some of the textile manufacturers about this they said they hire workers on contract. So the industrialists have found a way to go around the laws, which is probably why I think employment is higher than what is reflected in the official statistics. Of course labour hired on contract does not enjoy as much protection from the labour laws. So it's a real distortion not only in the way manufacturers are hiring labour to expand but also in the way this labour is protected.

Overall, I think the labour laws are a constraining factor in generating a genuine labour-intensive pattern of development. China, of late, has been making some noises about replacing the dollar as the international currency for trade. What do you think are the prospects of that?

It's not only the Chinese, many others have also asked such questions. First of all from the broad historical perspective, we had the pound sterling as the international reserve currency for a long time. But that currency declined when the US became an economic superpower, so the dollar replaced the pound.

Now the question is if the dollar declines what currency will take its place. Some say that the Chinese currency can. But that is difficult because the Chinese currency is not convertible. Right now you can't use the Renminbi for international trade. For the Remnimbi to become convertible the Chinese capital account has to be opened up much more. The Chinese are promoting the use of the Renminbi but only in trade. So they're entering into bilateral agreement with countries where they're given a Renminbi line. But that can only be used to buy goods from China. You could argue that the Chinese are preparing the ground but there is still a long way to go before the dollar can be replaced.

Unlike the last time when the dollar replaced the pound, there is no another currency waiting in the wings to take over. For that reason, the dollar will remain as the currency for international reserve for a while.

Of late there has been a call to make the IMF a more open, inclusive and democratic institution reflecting the concerns of emerging economies. How is the IMF responding to that, what are your views?

First let me address the openness issue. When I joined the IMF 21 years ago, we were not an open institution in any sense of the word. But now we are a lot more open. If you look at our Web site — which may not be one of the best organised — all the information is there, except for the most market-sensitive information.

In that sense, the Fund today is a very open institution and I say that because it has a bearing to your second question which is, is the Fund open to criticism, and I think it is. An institution cannot have legitimacy unless it is properly represented by its members. If you have an institution where the membership is skewed in some way, over time this institution will erode.

So for the sake of the institution itself it needs to be more representative. This has been recognised almost five years ago when the first steps were being taken for reforming quotas. That is the first adjustment was taken in 2007 and another adjustment will have to be taken by January 2011. There have been pledges made by the G20 and the IMF that this will happen. There has been a pledge that about 5 per cent of quotas will be shifted towards emerging markets. Now there are formulae used based or population, GDP growth, etc for arriving at the quota subscriptions and voting rights. Given the relative sizes of the economies the US will remain the single largest shareholder. What changes is the relative positions of the smaller Western European countries vis-à-vis the emerging economies. That process is underway and will be completed before January 2011.