Boom Time in India: Wrestling the Inflation MonsterPublished: July 05, 2011 in Knowledge@Australian School of Business
After 15 years of astonishing growth, the Indian economy is now the world's 10th largest in terms of gross domestic product, and it's predicted to be literally top of the world by 2050. While that may seem a way off, it should be remembered that India's mighty growth phase – post-1947 independence – also was a very long time coming. Kaushik Basu, a professor of economics at Cornell University in the US and the chief economic advisor to the Indian Ministry of Finance, says two reforms had a major impact on India's economic surge – the removal of an arduous business licensing system and a dramatic lowering of tariffs. However, India continues to be criticised for over-regulation and is now challenged by the economic "disease" of alarming inflation. Basu tells Julian Lorkin of Knowledge@Australian School of Business that, while a disproportionate amount of his time right now may be taken up tackling "the inflation monster", India's growth story looks set to continue.
An edited transcript of the interview follows.
Knowledge@Australian School of Business: Let's start with the back story. What happened to the Indian economy after India achieved its independence in 1947?
Kaushik Basu: For the first 30 to 40 years, the economy grew very little. Very important things happened on the political front, the democratic structure was set up very, very successfully, but no one would describe India as an economic success story up to the mid-1980s. The country's gross domestic product used to grow at 3% to 3.5% per annum and most of it would be swallowed up by the population growth rate, which was very high. It was jocularly called the "Hindu rate of growth". Somewhere in the 1990s that all changed very dramatically over a relatively brief period. In the early years of independence, India was getting a lot of praise for its experiments with the democracy but very little for the economy.
Knowledge@Australian School of Business: Can we pinpoint exactly when the changed happened and what caused it?
Kaushik Basu: I put a finger on the early 1990s – from 1991 to about 1994. I think this is the predominant view. And it's easy to see what happened. With the first Gulf War (August, 1990 to February, 1991) in 1991, the Indian economy ran into a crisis for a very strange reason. At that time, India was not a very open economy so a disproportionate amount of our money came in as remittance from Indian workers in the Middle East. With the first Gulf War that source of money ran dry and India's balance of payments situation was on the verge of going bust. Big reforms were undertaken from 1991 to 1993 by the then Finance Minister of India (Manmohan Singh) who's now the Prime Minister of India. And within a year or two you could see the impact on the economy. In 1994, India began growing at 7% per annum; it grew for three consecutive years at that rate, double what I just called the Hindu rate of growth. That itself was a big surprise. India had been used to a hand to mouth existence. Then, in 1993, foreign exchange reserves started picking up from a customary US$5 billion, and over the next 14 years they reached US$300 billion. By 1994, the economy had picked up, but the really fast growth came from 2004/5.
Knowledge@Australian School of Business: Are there any specific reforms that you can nail down as a real turning point?
Kaushik Basu: There were many reforms. If I had to, I would pin down two. Firstly, India had a notorious industrial licensing system, so if you wanted to start up a farm you needed a licence and you will be given a run for your money to get that licence, with the consequence that new enterprises often could not start up. This was revoked in 1991. The licensing system was basically thrown out of the window. Secondly, from the time of independence, India has always been a very culturally open society. We would get movies from Hollywood, and newspapers and other media (from around the world), but we were not a very open economy. We used to raise our tariff rates and not allow foreign goods to come in. There was a dramatic lowering of tariffs from 1991 to 1993. So opening up the international sector was a major reform and the industrial de-licensing was a major reform. There were other things but, for the drivers of the take-off, I would point to these two.
Knowledge@Australian School of Business: Bringing down tariffs was quite controversial at the time. Now many countries are looking at increasing tariffs. Is there a lesson for the rest of the world here from comparing a country with and without tariffs?
Kaushik Basu: There are advantages in a crisis. There are things you can do which you would not be able to do at another time. I'm in no two minds about the need to bring down tariffs and keep them at a very low level – you want trade to be as open as possible. I think it's worth doing for all countries. Very often it's tied up with currency flows. Do you open the gates to currency flows fully or not? I should tell you India has restrictions on that so we allow current account flows, but on huge capital movements there are some restrictions. Opening up trade, lowering tariffs, but keeping some restrictions on capital flows, because we don't want destabilising of the currency – this combination is working very well for India. If you're going to the US to study and you are going to take quite a bit of money out, there are no problems. But if you want to invest in another country, there are some restrictions still on that.
Knowledge@Australian School of Business: If we look at growth, the GDP in India is powering ahead quite strongly. If you look at purchasing power parity, which compares the long-term relative price levels of different countries, India's now number four in the world. It's a surprise for many people.
Kaushik Basu: It's a surprise even for Indians. When I began as a professor at the Delhi School of Economics in the late 1970s, we were proud of India's political experiments, but no one really thought that the economy was something to talk about. We were reconciled to the way it was – a vibrant democracy with slow chugging growth. But now the story changed and India is talked of as one of the growth leaders in the world. Fifteen years ago we couldn't imagine India being fourth in the world with the PPP (purchasing power parity) correction. Part of that is the population as well. We are a big country so the population adds to that. When it comes to per capita income, it's still a country that's just picking up. However, the growth rate is just phenomenal.
Knowledge@Australian School of Business: But look at inflation, it's the Western disease now feeding into the Indian economy. At the moment, inflation is 9%, but a year ago it was up at 16% – that's a level where most economists get twitchy.
Kaushik Basu: Inflation has been the big worry, but let's put this in perspective. Emerging economies in Latin American countries have had inflation levels of 2000%. And the biggest inflations were in Europe between the two world wars and after World War II. This is nothing compared to that. Historically, India is a country with very low inflation so once inflation crosses 10%, politically it gets very destabilising because the poor and the vulnerable can feel the pressure of prices. However, you have to keep in mind, that last year India's nominal income grew by about 20%. Inflation was 11%, so inflation took away from that and left 9% as real growth. There's more food, clothing and housing – a cushion of real growth, which is allowing us to tolerate a level of inflation that would not have been tolerable earlier. Having said that, one of the biggest challenges for government right now is inflation. A disproportionate amount of my time in India is spent talking and thinking about ways to tackle the inflation monster.
Knowledge@Australian School of Business: In a recent report on the Indian economy, the Organisation for Economic Co-operation and Development (OECD) says inflation is going to be a worry and there is a lot of fiscal tightening. Is India in the very lucky position that many countries aren't, where you can actually clamp down on rising inflation? Alternatively, is it going to spiral out of control?
Kaushik Basu: No, I don't think so. Actually the inflation is bad enough now, but I think we are seeing the worst of it behind us. As you just mentioned, a year ago it was much higher. So I think the trajectory is right. Over the last year and a half our central bank has acted nine times to tighten liquidity. At the Ministry of Finance, where I am based, we are working on tightening our fiscal deficit. The two are running very much in tandem over about a year and a half. I think the slowing down of inflation over the last year is a response to these policies. Inflation is going down far too slowly for my comfort, but I don't think there's any question of it galloping out of control.
Knowledge@Australian School of Business: People saw what happened with the Asian financial boom that suddenly turned into a crisis – there was host of deregulation and currencies were allowed to float, and it turned into a great big bubble. There has been speculation about a similar risk with the Indian economy.
Kaushik Basu: There are certain parts of the economy where a bubble can arise and it would be foolish to say that can't happen. For instance, in the housing market, we are not in a bubble, but a bubble can form and a bubble can burst. We've seen this in the strongest economies. Any good economist should expect that segments can get into a bubble and collapse. However, with the growth story of India, I don't think there's a bubble at all.
The Indian economy has picked up in stages – first in 1994 when growth went to 7% and stayed fairly constant. It broke into 8% in 2003 and by 2005 the growth was at 9%, which is astonishingly high, but it was there for three years until the recent global financial crisis, when it slowed down a little bit. Even in the middle of the global crisis when the GDPs of most countries in the world were shrinking, it was negative growth. India's worst year was a growth rate of 6.8%, so I feel the growth story is here to stay. It's been with us for 15 years. There will be segments where bubbles will form and bubbles with go. We try our best not to let that happen, but we know we have to live with some.
Knowledge@Australian School of Business: I'm sure there are many countries where they'd love to see a growth rate of 6%. At the same time, the recent OECD report said it would like to see less regulation to free the market up even more. Is that possible in India?
Kaushik Basu: It certainly is something that we should go for. I am with the OECD on this. Within India, there are important areas in which we have restrictions currently, but there is debate about opening these up. I've been involved in the debate about retail outlets. India does not allow multi-product retail. For example, Walmart can't be there. But there is now a discussion about opening up this segment. You allow foreign direct investment to come and big corporations will come in. I don't know whether it will happen, but it's very likely. There are several important areas of reform where Indian opinion is running along the same lines as the OECD.
Knowledge@Australian School of Business: Finally, what can Australia learn from this about having less regulation and a free-market economy?
Kaushik Basu: Australia has done really well. Among industrialised countries, Australia stands out in a way that's somewhat similar to the way India stands out among emerging economies. From the mid-‘80s, Australia began liberalising and it has seen a lot of advantages from that and likewise for India. I think it's worthwhile opening up trade. You can't run a modern economy without government regulation, but you have to keep it moderate. Earlier, India made some mistakes in seeing some evil in a sector and regulating it so much that the sector went out of existence. That's the kind of thing that you have to guard against. That's true for India and for Australia.