To facilitate long-term infrastructure investment, there is a need for sound long-term macroeconomic policies, writes S. S. Tarapore in one of the essays included in ‘Building from the Bottom: Infrastructure and poverty alleviation,’ edited by Sameer Kochhar and M. Ramachandran (www.academicfoundation.com). Two things that Tarapore focuses on, in his essay, as necessary conditions, are policies about interest rate and inflation.
Reasonable interest rate
Beginning by stating that in a stable system the long-term interest rate is the average of the expected short-term interest rate, adjusted for uncertainty and risk, the author urges that for infrastructure investment to be viable, the long-term interest rate has to be reasonable. As a rule of thumb, he adds that if the long-term real rate of interest is above the real growth rate of the economy, it cannot be sustained and the growth rate will decline.
“The logic for focusing on short-term interest rates is that for long-term interest rates to be conducive for infrastructure investment, the average real short-term interest rate has to be reasonable. For real short-term interest rates to be reasonable, nominal short-term interest rates have to be moderate and this requires that the medium/long-term inflation rate has to be moderate.”
‘Massaged’ inflation indices
As for inflation, Tarapore insists that there must be some element of credibility regarding the computation of inflation. It is not enough for the government to claim that inflation is under control but the general public has to be convinced that inflation is moderate, he says. “The world over, inflation indices are ‘massaged.’ To put it bluntly, the public perception is that governments, the world over, take recourse to ‘cheating’ to dampen inflationary pressures.”
Fretting that the lack of credibility of the inflation numbers has become very acute in India during the recent period, he mentions that while the wholesale price index (WPI) shows a relatively low year-on-year inflation rate, presently around 10 per cent, some consumer price indices (CPI) show an inflation rate as high as 17 per cent.
What the author finds alarming is the perception of the common person that the inflation rate at the grassroots level is much higher than what is reflected in the official indices, even as many reputed analysts simply take the official line that what is important for policy purposes is the WPI and that the authorities should continue to focus on accelerating growth.
Tarapore calls for a revamp of the official price indices to restore confidence in the general public. To this end, he recommends that a High-Powered National Inflation Commission be set up, with clear powers to oversee the inflation numbers and also to prescribe the acceptable rate of inflation. “It is not necessary to have a single inflation target using a single instrument viz. monetary policy. The important thing is that the authorities should be transparently committed to contain inflationary pressures and subterfuge should not be resorted to hide the ‘true’ rate of inflation.”
Indexation to inflation
Reminding that control of inflation is at all times a sound policy, the author cautions that India could be making a serious mistake in drawing wrong conclusions from around the world that inflation control is not a good policy. “There is a strong lobby in India which stresses that inflation is a supply-side problem and therefore a strong monetary policy is redundant. While sectoral inflation in one or two commodities could reflect supply-side problems, generalised inflation cannot occur without excessive monetary creation.”
Another suggestion in the essay is about indexed bonds. The author reasons that a commitment by government to issue inflation-indexed bonds at a reasonable real rate of interest would go a long way to generating an element of credibility of the government’s resolve to control inflation. The indexation, he explains, should be to a credible consumer price index with, say, a 3 per cent real rate of interest.
“If the inflation rate in a year is, say, 7 per cent, then the bond holder would be paid 10 per cent for that year. Moreover, if, over the life of the bond, the cumulative inflation at the end of 10 years is 50 per cent, the bond holder on a face value of Rs 100 would receive proceeds on maturity of Rs 150.”
To opponents of indexed bonds, who fear that indexation can become all pervasive and in a sense condone inflation – as in the case of Scala Mobile, or automatic indexation of the entire economy, which ruined Italy in the 1970s and 1980s – Tarapore clarifies that what India needs is not an all pervasive automatic inflation indexation.
Instead, the government could ensure that only one bond with a long maturity, say 10 years, is indexed and kept open on tap during the year and this should be available only to individuals who are senior citizens (age 60 and above) and subject to an annual individual investment ceiling of say Rs 5 lakh, he elaborates.
“There should be no tax benefits on interest income, though capital gains should not be taxed on the maturity proceeds. Such a Nani-Dadi Indexed Bond would then provide a vital benchmark for raising long-term debt for infrastructure.” For, it would just not be possible to raise long-term resources for infrastructure if there are strong disincentives for savings and interest rates are repressed and the authorities have no concrete and visible commitment to control inflation, the author argues.
A section on ‘pitfalls in financial engineering’ warns one of the obvious dangers in ‘plundering the RBI’s forex resources with improper accounting.’ Reminiscing how the India Infrastructure Finance Company Ltd (IIFCL) was set up – in a context when the fisc is strapped for resources and the existing financial institutions cannot overcome the asset-liability maturity mismatch – the author avers that the facetious resolution of the financing problem, with the RBI required to provide foreign exchange resources to the IIFCL against the collateral of the new institution’s own bonds was ‘nothing short of a financial fudge.’
It is quite legitimate to use the country’s forex resources, but anyone, including the government, wanting to use forex resources should be prepared to down the requisite rupees, Tarapore counsels. “Making the RBI to accept the bonds of an institution in lieu of cash rupees is most unfortunate. Such kinds of dubious transactions if resorted to frequently will weaken the RBI balance sheet…”
An instructive example that the author draws from the past is about how India undertook large increase in steel capacity in the 1950s, and met the foreign exchange portion required for building the steel plants in Bhilai, Durgapur and Rourkela, by raising funds abroad. “Forex reserves were drawn from RBI and in lieu, rupees were downed by the government which reflected in the visible fiscal deficits going up in the second half of the 1950s. Such transactions could not be faulted.”
In contrast, the recent saga of using RBI forex funds without paying rupees in cash is creating resources out of thin air and is tantamount to window dressing of the fiscal deficit, the author grimly observes.
Educative collection of insights.