The Hindu Business Line : Easing supply-side pressures

Though Budget 2007-08 was presented just after elections to a clutch of State Assemblies and ahead of hustings for some more, the Finance Minister, Mr P. Chidambaram, also had an important economic objective — of arresting the price rise, which has been hovering around 6.5 per cent for quite some time now. The economic objective has an overriding consideration as it touches the lives of common man across the country.

Examined by the Keynesian framework, the country seems to be facing inflationary pressures from the gap between aggregate demand and supply. The Keynesian model of income determination suggests that the aggregate demand consists of private consumption and investment spending, government spending, and net exports.

According to the Reserve Bank of India's latest Annual Report, the economy-wide final consumption spending grew dramatically from 1.2 per cent in 2002-03 to 7 per cent in 2003-04, and remained around that level even in 2004-05. The combined investments of the private sector and the government grew little over 15 per cent three years in a row till 2004-05. In fact, the average growth rate of fixed investment during these three years was 10.2 per cent. Merchandise exports grew 23 per cent in 2005-06 against 30.8 per cent in 2004-05. But `non-oil, non-gold' imports grew 23.7 per cent in 2005-06 and 39 per cent in 2004-05. Though there is not much net gain, the gap between the two narrowed considerably in 2005-06.

Investment Surge

For the last two years, the aggregate demand in the economy was largely driven by the surge in investments. According to the CSO's latest release, the gross domestic capital formation was 31.5 per cent of GDP in 2004-05 and should be 33.8 per cent in 2005-06. For the first time since Independence has the economy achieved such a high investment rate. As per RBI's estimates, the domestic savings rate went up from 28.9 per cent in 2003-04 to 29.1 per cent in 2004-05 due to the turnaround in the savings rate of the public sector. The RBI also notes that while the domestic savings rate (as a percentage of GDP) improved by about 0.2 percentage points, the investment rate went up by about 2.9 percentage points, suggesting that the domestic investment is increasingly financed by foreign capital. This can happen only if the demand situation in the economy is sound. If these tendencies are any indication, there are a number of reasons to believe that the economy is performing well on the demand front. Considering these facts, the Budget has tried to address the supply side. Conceptually, aggregate supply is the quantity of output that firms would be willing to supply. Extended to the Indian context, the aggregate supply becomes an outcome of several factors such as production, capacity utilisation, technology and so on.

Growing Services

A sector-wise analysis indicates that services continued to grow at the expected rate of little over 10 per cent successively in 2004-05 and 2005-06. In the same period, industry recorded an average growth of 7.5 per cent. However, the agriculture growth rate went done sharply from 10 per cent in 2003-04 to a meagre 0.7 per cent in the next year, though it increased to 3.9 per cent in 2005-06.

Of the several factors limiting agriculture production, monsoon is critical. Given that 2005 received close to normal rainfall, the recovery staged by agriculture in 2005-06 is easy to explain. However, production of foodgrains was 208.3 million tonnes in 2005-06 compared to 213.2 million tonnes in 2003-04, which was a good year for agriculture. Yet, production of pulses did not change much; it remained at 13.1 million tonnes consecutively for two years compared to 14.9 million tonnes in 2003-04.

Clearly, the country's ability to achieve higher production depends upon rainfall. Is there any way to improve this situation? First, the system of water collection and preservation should be improved. Second, productivity in agriculture should be stepped up. In fact, Budget 2007-08 has outlined several schemes to restore water bodies and to concentrate on watershed development and programmes for water harvesting with the active participation of local bodies.

The Budget also places primacy on improving quality of seeds. These initiatives will help augment existing irrigation system as well as productivity in agriculture, and subsequently ease supply constraints. It is, however, capital formation in agriculture that holds the key for insulating the economy from the ups and downs of the monsoon. Thus, a point of worry is whether the reduction in the Plan expenditure would adversely impact public investment in agriculture.

Industry Upbeat

Going by the Index of Industrial Production, there has been a surge in the industrial production. Limits to aggregate supply through industrial production are largely due to capacity utilisation and application of technology. According to the RBI's Annual Report, the weighted average capacity utilisation in industry was 82.7 per cent in 2005-06, a marginal rise from 82.2 per cent in 2004-05. On a balanced consideration, the capacity utilisation of industry has been up to the mark and would have contributed to easing the supply constraints. Industrial production also depends upon the level of technology. Given the weak domestic base, firms will be encouraged to import technology if the Customs duty on import of machines is reduced. The Budget proposes just this. It also retains the incentive structure to boost Research and Development by domestic firms.

The aggregate supply is impaired also by the infrastructural bottlenecks. As the RBI's Annual Report suggests, the infrastructure industries suffered from negative gap between the target and achievement during 2005-06 excepting coal, cement, petroleum/refinery products and natural gas production. In line with the long expectation of the experts, the Budget, for the first time, proposed RBI lending to borrowers who will, in turn, invest in infrastructure development.

The Budget's additional commitment to the national highways projects should help ease the infrastructure constraints. The stepping up of the social spending on health, nutrition, drinking water supply, sanitation and education would help improve the quality of human capital.

Viewed from these angles, Budget 2007-08 was a significant departure from its conventional approach of demand management to giving more attention to the supply side. Several of the Budget proposals are likely to have an impact in the short run, while a few will benefit the economy in the long run. But the point is that the short-run effects will carry the potential to close the gap between aggregate demand and supply and thereby containing the inflationary tendencies. This Budget is a step forward to harmonising the objectives of fiscal and monetary policies to the price level.

(The author, a Faculty at The ICFAI Business School, Bangalore, can be contacted at dennisraja@hotmail.com)