It is as yet not time, some in the government argue, for withdrawal of the fiscal stimulus launched in response to the crisis-induced slowdown in growth. That has generated expectations of the fiscal policy stance it would take in the budget for 2010-2011 due in less than month. But the Reserve Bank of India’s assessment of the state of the economy in its Third Quarter Review of Macroeconomic and Monetary Developments and its decision to hike (in two stages) the Cash Reserve Ratio by 75 basis points to 5.75 per cent of net demand and time liabilities in order to absorb Rs.36,000 crores of liquidity from the system suggest that the official reading of the situation is changing.

The RBI’s move is a small step in the direction of monetary tightening, with all key interest rates such as the repo rate and bank rate left untouched. But it points to a shift in stance away from a focus on growth to one of dealing with inflation. This is not surprising. Inflation, when measured by movements in the Wholesale Price Index (WPI), stood at 7.3 per cent overall and 21.9 per cent for food items in December 2009. Though, as of now, inflation is focused on food, the RBI observes that there are signs of more generalised inflation starting December 2009. In sum, the era when high GDP growth accompanied low or negligible inflation seems to be behind us.

In response, the Reserve Bank of India has decided to advise the government to set out the road map and traverse the route to fiscal consolidation. In its view: “The counter-cyclical public finance measures taken by the government as part of the crisis management were necessary; indeed they were critical to maintaining demand when other drivers of demand had weakened. But as the recovery gains momentum, it is important that there is co-ordination in the fiscal and monetary exits. The reversal of monetary accommodation cannot be effective unless there is also a roll back of government borrowing.” It therefore recommends, “a phased roll back of the transitory (fiscal) components” in the form of reduction in excise levies, interest rate subventions and additional capital expenditure.

These are pointers to the dilemma the government faces. On the one hand, it would like to keep the “recovery” going. While GDP growth has touched 7.9 per cent during the second quarter of 2009-10 as compared with 5.8 per cent in the last two quarters of 2008-09, it is still short of the close to 9 per cent rate recorded over a relatively long period stretching from 2003-04 to 2007-08. For a government obsessed with taking the growth rate back to 9 per cent and pushing it further to 10 or more, this is reason to fiscally prime the system. Moreover, as the RBI’s review makes clear, the recent recovery was largely driven by the 12.7 per cent growth in “community, social and personal services” resulting from the large payouts of arrears associated with the implementation of the Sixth Pay Commission’s recommendations. But for this, the growth of the services sector, which accounts for 65 per cent of GDP, would have been only 7.0 per cent as opposed to the actual 9.00 per cent recorded during the second quarter of 2009-10. That would have cut aggregate growth to around 6.5 per cent, which would be unacceptable both to the government and to stock market players. Since the payment of arrears is a onetime affair, these expenditures would be only partially sustained, to the extent that some arms of the central government and some state governments belatedly implement the award. This defines the difficulty that confronts the government to keep growth going. It needs to hike expenditures to make up for the absence of the stimulus delivered by arrears payments. But, that would sustain aggregate demand and possibly fuel inflation further.

The only factor favouring the government is the limited level of protest in the face of inflation. Till quite recently the presence of or movement towards “double-digit” or 10 per cent or more inflation was adequate to precipitate mass protest and destabilise governments. Compared to that, the current level of protest when food price inflation is running in the 20 per cent range must be comforting. Two factors possibly account for this. First, the government has won the implicit or explicit support of sections of the vocal middle class that were earlier responsible for leading the protest, articulating its content and mobilising support. They have been coopted by favouring them with some of the benefits of growth. Second, with the next set of elections that are significant enough to begin to redefine the political landscape still distant in time, opposition parties have been lackadaisical in taking political advantage of the opportunity to weaken the incumbent government that high inflation offers.

But sporadic protests in different parts of the country are increasing in number and gaining in strength. This would strengthen the case of those within government who are arguing for contraction vis-a-vis those who would like to consolidate the current advantage the UPA government has by stepping up expenditure.

The issue then is whether the government can find itself a credible way of dealing with inflation, even while hiking expenditures. It is widely held that speculation plays a key role in explaining the high rate of inflation in the prices of food articles. But the success of these speculators in ensuring that their expectations of a rise in prices are realised rest on long term supply-demand imbalances resulting from the neglect of agriculture and errors in supply management in the case of commodities like sugar (in whose case surpluses accumulated in the past were dissipated through large scale exports). The real advantage the government has is the foreign exchange reserve the country has accumulated, which facilitates imports to augment supplies and dampen inflation. But there are three difficulties here. First, as the RBI’s policy review statement notes, “the global rates of increase in the prices of sugar, cereals and edible oils are now appreciably higher than domestic rates”, so that the opportunity to use imports to contain domestic food prices is limited. Second, even where imports can be resorted to, managing distribution to reach supplies to where they are needed is not easy given the limited spread of the public distribution system. Third, if supplies are successfully distributed it may dampen inflation in the short run but discourage domestic production and worsen supply-demand imbalances in the medium term. That is, the difficulty of sustaining high growth with low inflation would only persist.

This calls for innovative economic management rather than just a knee-jerk effort at contraction. With a mandate that assures a stable, full-term government, the UPA can afford to think of medium term measures aimed at strengthening the country’s development prospects. The appropriate strategy would be to combine short-term supply management and improved distribution with a level and pattern of expenditure that would redress supply-demand imbalances. This requires a shift in perspective because these imbalances were generated over the years when high GDP growth based on an expansion of services and selected manufacturing sectors were not just considered a viable long term strategy of growth but lauded as unique. The best bet for the UPA would be to use a part of the foreign exchange reserves to manage supplies, undertake expenditures in this and future budgets to redress imbalances that threaten chronic inflation, and adopt policies in different areas to make growth more broad based.