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IMF has been surprised by India's strength: Raghuram Rajan
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September 15, 2006 15:00 IST

The International Monetary Fund and the World Bank are holding a series of meetings in Singapore. This is the first time, since the Asian meltdown of 1997, that such a meeting is being held in Asia.

More importantly, IMF has raised India's 2006 growth forecast to 8.3% from 7.3%. IMF's Chief Economist Raghuram Rajan explains why.

Raghuram Rajan says that the growing strength in manufacturing will help 8% GDP growth. He further adds that more reforms are needed to maintain 8% growth rate. Rajan feels that manufacturing and service sectors have surprised on the upside.

Excerpts from CNBC-TV18's exclusive interview with Raghuram Rajan:

The forecast for India is that there is a quantum jump from 7.3% to 8.3%. On what is this confidence predicated?

It is predicated on the Indian economy doing very well. I think the strength of the industrial sector, the manufacturing sector as well as services has surprised a little bit on the upside.

But also we were factoring in more of a slowing, perhaps as a result of higher oil prices, and I should say that we have been surprised by the strength, not just of India, but of emerging markets in general.

They have withstood the higher oil prices quite well. In India, to some extent it has been because some of it has been absorbed and not passed on, it has been absorbed in the government books. But also what has been passed on has been absorbed quite well by the industrial sector.

Would you say that this 8% plus rate of growth therefore can become a minimum expectation for the Indian economy for the foreseeable future, would you say that 2007 could therefore be a given in terms of 8%?

Well, I am not so sure about that. Our projections for 2007 are lower than for 2006. 8% is an incredibly high growth rate, it looks relatively small when you compare it to China's 10%. But compared to any other economy, it's incredibly high.

Lots of things have to go right to keep it at 8%. I think one of the good pieces of news on the Indian front is certainly the growing strength of manufacturing and the growing comparativeness of manufacturing.

I would think that when combined with the strength of the service sector, we would expect fairly high growth rates for India, barring unforeseen eventualities going forward. But for 8% I think, in order to be confident of continuously achieving that, we need more on the reform front.

What are you expecting in terms of interest rates and inflation? Are you expecting that the Reserve Bank will have to tighten interest rates further in 2006 itself or more certainly in 2007?

It's hard to say. I think inflationary pressures round the world are picking up and some of that will come through to India. Labour markets are tight around the world, especially at the high end. You see that in India too; wage growth of the high end is really growing very fast.

But also, commodity prices have increased considerably and there are pipeline pressures from that. The question, however, is whether there is some give back from commodity prices.

Oil prices have fallen in recent weeks, and with volatility, it's not clear whether this will persist. But if it does, that would be a boon to countries like India, which used a lot of oil.

So I would say there is a certain sense of wait and see, but in general, the direction for inflation is higher, which would mean the direction for interest rates is also going to be higher.

Commodities seem to be a conundrum at this point in time. We are seeing a softening in crude prices and we are perhaps seeing that it has spread to base metals as well. Therefore, would you say that this softening is likely to continue in 2006 and 2007 since you are calling for a lower US GDP growth rate?

What we can be confident about is volatility. The supply situation, both in oil as well as in some of the metals is very thin at this point. In the medium term, we expect the supply situation in metals to be remedied and there will be a lot supply coming on stream. So for metals we expect prices will fall in the medium term.

Emerging markets are still going strong. These are very commodity intensive, oil intensive economies and therefore one would expect that they would add to demand. So I think on the oil front, I don't see this as a secular change, I do think there will be continued volatility going forward, given the very tight supply-demand situation.

Your executive summary hints that you are expecting the US Fed will have to tighten rates further. To what extent are you expecting that the US FOMC may have to tighten rates and by when do you think this pause might end?

I think right now there is a two-way uncertainty. We have the housing markets slowing a little faster than people anticipated, and at this point the amount of housing stock has built up. So I expect that there would be a certain amount of price correction going forward.

Of course, on the supply side housing construction has fallen off considerably, so we hope that the balance will be reached before prices move much further in the downward direction, that's as far as housing goes.

Housing has to feed into overall demand, and that hasn't happen yet. Consumption is really quite strong in the United States barring perhaps the auto sector. Some of these is because wage growth is still quite strong in United States and job growth is also strong. So there is a big question about whether consumption does get affected by housing, and if so, by how much.

The next big question is on inflation, because wage growth is strong and because productivity has been falling in the United States. So there is a question of whether unitary labour cost have been going up quite fast, and that adds to the effect of commodity prices and increasing input cost.

If they are passed through to the final consumer, then that will mean higher inflation.

So the Fed at the same time is watching demand slowing down because of housing, but is also keeping an eye on the supply side, and seeing whether the cost pressures are going to push inflation higher. And that's why it's pausing.

Now it could go down the line and say demand has fallen off too much and we should cut interest rates- and that is certainly what the market is expecting. But it could also say that inflationary pressures are still quite strong and therefore we should raise interest rates.

So we believe that we could come out of this pause in either direction. And the question is how long can we afford to wait, because if inflationary pressure gets entrenched, it will be much harder to bring down inflation.

When are you expecting this dilemma to come to fullness? Are you expecting that in end 2006 itself, or you think that it might happen in 2007?

It's very hard to say. I think it depends on the data and how strong it is. I think eventually all central bankers have to make decisions based on limited data. So the Fed has to get a fairly strong feeling that either the demand side is holding the weight or the supply side. I think that's anybody's guess.

How do you see the dollar panning out?

Do you see the dollar weakening versus the majors and versus the rupee? What is your call on the rupee?

I don't want to make a short-term call on any currency. Experience and research has shown that it's very hard to predict the direction of currencies. But I think in the medium term what has to happen is that exchange rate appreciations has to accompany the process of adjustment of current account balances.

So if the US is going to reduce its current account deficit there will have to be an appropriate depreciation of the dollar. The currencies that it has to sort of weaken against are more likely to be some of the emerging market currencies that have remained fixed against it, rather than currencies like the rupee which have been more variable. In our sense the rupee is relatively fairly valued at this point.

But going forward, since you are expecting a steaming rate of growth, would you say that rupee appreciation is more likely, in what is left of 2006 and maybe early 2007?

I will refrain from making a short-term prediction about the direction of the rupee.

There is a point in your emerging markets analysis, where you have said that countries at risk in the emerging market basket, are those with still weak public sector balance sheets and large current account deficits? Now that fits India like a glove. Are you saying that these two dangers can actually impact the kind of positive growth forecast that you are making?

I wouldn't say that it completely fits India because I think the public sector balance sheets need remedying and the fiscal deficits need tightening. The current account deficit is growing but it is still not at an alarming level.

Moreover, I think India's reserves are enough to buffer a "certain stop" in the inflow of foreign capital. So I think growth implications for India are less dangerous at this point. What I do worry about more in the case of India, is whether the fiscal deficits will start crowding out private sector investment because they both are competing for the Indian rupee.

You touched upon the fact that Indian growth, to remain in that 8% bracket, needs reform. Can you elaborate, what would be your top three list of reform initiatives that the government must take?

First, I think there is an immediate need for improving the power situation. I think that clearly needs a substantial amount of investment and it also needs very clear rules on the power sector side. It may need some private-public partnership, but I think enticing the private sector back into the power sector is very important. And we need to do what it takes because power is so critical.

The second thing, which we need to think about, is a reform of the labour laws. But here, I think it needs to accompany other reforms; for example, creating more of a safety net for the workers so that they are not left at the mercy of a 'hire-and-fire' situation.

I think it needs to be thought of as a package, not just making workers easier to hire and to lay off, but also to ensure that they have a reasonable safety net. So those are the two very important steps that need to be taken.

The third, of course, is rural infrastructure. I think we need to connect rural areas to the coastal areas and to the cities, and then to export markets so that there can be more value additions in agriculture because certainly a big part of our population is still in agriculture.

Do you have an opinion on the ongoing controversy on SEZs in India?

My view is that the tax incentives should be very limited in these SEZs. If one creates substantial tax incentives, which becomes the reason for setting them up, I think the reason for setting them up should be better infrastructure.

And perhaps more flexibility in some of the laws, less red tape, so that one can get more investments, which would not otherwise go into the rest of the economy. By creating tremendous tax incentives, one reduces the pressure for the promoters of these SEZs to create the right kind of infrastructure for state governments and to create the right kind of rules in these SEZs.

And one could focus on tax incentives, which then could lead to a lot of investment coming up here, which would otherwise have gone in other areas. It could lead to a concentration of industry in some of these areas, not because they are the best places to be, but because there are tax sops.

So I would limit the tax incentives focus more on getting everything else right, and that I think would serve India well.

If we talk tax, can deficit be far behind; do you think that these kinds of giveaways as well as the pressure on employment generation and other Common Minimum Programme initiatives can derail the government's deficit targets or do you think the growth will make up for it?

It is always tempting to think growth can make up but certainly budgets have limits and I think the government faces a very important situation that we cannot allow inequality in India to grow beyond a certain point, it is very important for the government to attack that and to make sure inequality does not expand too much but there are good ways and bad ways of reducing inequality.

The good way seems to me is to do all the good things that the government has to do, such as improving the quality of education, expanding access to education, healthcare and job opportunities by creating an environment for business to set up.

The bad way is to offer guarantees of one kind or the other. It seems to be like, the more we focus on the form of creating opportunity and the less we focus on offering guarantees of one kind or the other, the more it will be a growth-promoting inequality reduction programme rather than the growth-subtracting inequality reduction programme.

Two surprising statements from you, your stress on inequalities and poverty and your stress on labour and the fact that 'hire-and-fire' should not become the order of the day, these sound very un-IMF like, are these the reasons why you are going away from IMF into academics?

No. First of all, I wasn't saying 'hire-and-fire' was not required, I think it is required because there are industries in which there is a lot of volatility in output. And for India to enter those industries and be competitive, for example textiles, one should have the ability to be able to lay off workers when there is no work.

That will add to overall employment because one can hire workers, when there is work, one can take on new orders without fear that one will be stuck with workers. So I wasn't against 'hire-and-fire'.

But I was saying that one cannot introduce a 'hire-and-fire' environment where there aren't other job protections. Because otherwise, how will workers who are fired, then react?

What is the trigger behind this decision to go away from IMF into the world of academics?

I came from the world of academics, I really like my job and I think we made a big difference over the last three years. It is just that at some point, academia rules on how long one can continue outside. And to some extent, I believe that I have done what I wanted to do.

Of course, it never ends but it has been a good run and it is time for me to go back to my other love.

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