Indian Economy at Mid-year 2015-16: Some Observations

Economic Growth

Q1:  The Mid-year analysis of the CEA, lowered economic  growth projections  sharply from 8.1-8.5 per cent for 2015-16. Don't you think  it  is  too  pessimistic a  projection since  the  UPA had left  growth at  7.9 per cent  for 2013-14? Even  upper band  is a tad  higher than 7.3 per cent recorded last  year.

A1:  At the end of 2014-15, most macro-forecasters(public & private) had predicted a GDP growth rate of over 8% for 2015-16 with a steady growth in the first half and a stronger pick up in the second half of the year.  Since then they have reduced their forecasts of GDP growth in 2015-16 to below 7.5%.

     I retain my post-budget forecast of a 0.25% to 0.75% acceleration in GDP growth in 2015-16 over previous year. Given that GDP growth rate was 7.3% in 2014-15, my  expectation remains of a growth rate between 7.5% and 8%, though current data suggests it will be on the lower side. On the positive side is the recovery of IIP manufacturing growth from negative growth at end 2013-14 to a growth rate of 4.5% to 5.5% at present. This is underpinned by a strong recovery in both capital goods and consumer durable goods production.  The two back to back droughts in 20014-5 and 2015-6 have however taken a greater than anticipated toll on demand for consumer durables produced by the organized sector represented in the IIP. A decent Rabi crop should help revive rural incomes and demand for non-durables consumer goods. This will, however, need to be re-evaluated as more data comes in January.

Q2: It said private investment may remain weak next financial year as well. What is your view?

A2: Assuming that all the financial sector reform measures outlined in the budget (eg bankruptcy law) and elsewhere, are implemented I expect a steady but slow recovery of corporate demand, investment and growth during 2016-17. This would be stronger if the right choice is made in the fiscal-monetary balance as suggested above. There is nothing in the data so far to suggest a very sharp pick up in private investment in 2016-17.

World Economy

Q3: What is the effect of the Global economy on India?

A3: Many analysts are just beginning to understand that we are living in a near-deflationary World economy and many still don't understand that the Global financial crisis (2008) was more akin to the Great Depression than the worst post-war recession.[i] This was masked to a large extent by US QE till 2011 and in the oil/energy market till 2013, by the Chinese debt bubble.  What this means is that the standard effects of monetary and fiscal and economic co-relations that analysts have got used to in the inflationary post-war world have been disrupted and often yield wrong answers.

      Though low aggregate demand in developed countries was important in triggering deflationary trends, it is has been underpinned by excess supply from continued production and investment in China unmindful of the near zero or negative returns. The largest effect of Chinese over-supply is on "un-differentiated tradable goods", which in earlier analysis of Indian economy I have termed  "Globalised (part of the) Corporate sector". 

   Coming specifically to the Indian economy, both the decline in oil prices, from which India benefits and the collapse of nominal sales, revenues and profits in the "Globalised corporate sector"(which surprised analysts) are the direct results of the demand supply imbalances in  "undifferentiated tradable goods." As any improvement in this sector depends on US-EU actions on fiscal policy and Chinese actions in abandoning its investment-export growth model, not much relief can be expected in the next few years. Consequently India has to focus on reforming policies that either constrain or could drive the growth of the non-globalised parts of the economy. This includes Infrastructure, Agriculture, Education, Real Estate and Construction, Defense and substantial segments of the Manufacturing sector

Fiscal Deficit & Monetary Policy

Q4: The analysis said meeting fiscal deficit target at 3.9 per cent in the current financial year would be challenging due to decline in nominal gdp growth, though the target would be met. Next year, the fiscal deficit target could be relooked at but no decision has been taken as yet as gains from declining prices would not be much, seventh pay commission is there and OROP is there. Your take?

A4: As I said after pay commission report, I Expect the current year's fiscal deficit target to be met. The greater challenge is from the equity sale targets, given the decline in the stock market since the budget. 

     For 2016-17, I believe there is a clear choice between (a) Sticking to announced fiscal target & loosening monetary policy in line with the decline in CPI inflation, which requires a repo rate cut of another 75 bps, or (b) holding monetary policy tight (much tighter in real terms than it was 18months ago) and letting fiscal targets slip by raisin govt investment in infrastructure. In my view the former choice is a better one for revival of corporate investment & growth, given other complementary policies.

Q5: How much of a repo cut do you think is still required.

A5: Inflation as measured by both the CPI and the GDP Private consumption deflator PFCE) have fallen dramatically in the past two years. The PFCE deflator has fallen from peak inflation rate of 11.3% in the 3rd quarter of 2013-14 (ie Oct-Dec 2013) to 1.4% in the 2nd quarter of 2015-16 (ie jul-Sept 2015). Similarly CPI inflation has declined from a peak of 11.7% Novemebr 2013 to 5.4% in November 2015 (ie -6.3% ). Over the same period the repo rate has been reduced by 1% (or 1.25% if taken from the subsequent peak). Therefore the real repo has risen dramatically resulting in a sharp tightening of monetary policy over the last year despite a reduction in the fiscal deficit. This is true even if we use the core CPI inflation rate which declined by 3.4%. Based on this decline I have repeatedly said that a 2% reduction in the repo rate can safely be undertaken.  However RBI has reduced the repo rate by only 1.25% points leaving scope for a further reduction of 75 bps.

   Now that the uncertainty over the US Feds rate hike is over, I would recommend an immediate Repo rate cut of 25 bps. If this does not take place now, then I would recommend a 50bps rate cut at the next Monetary policy statement.

---

[i] As I pointed out at the IMF from 2010 to 2012, the use of policies that worked in post-war recessions would likely extend this cycle by at least 2 years (ie 5-7 years) in the US and last at least 10years in the Euro area/EU(ie + UK).

Inflation & Monetary Policy 2015-16

Introduction

   This note takes stock of inflation and monetary policy during the last few years and draws implications for future. The most important conclusion is the need for a 1 to 2% reduction in the repo rate during the current  year.

Inflation

          Inflation as measured by the Private Consumption deflator (PFCE) is projected by the CSO in  2014-15 to be 5.4 per cent , down 3.1 per cent from 2013-14 and 4 per cent points from 2012-13.  It is likely to fall by another per cent point to 4.5% in 2015-16. Average annual CPI inflation mirrors this decline, with a 3 per cent fall between 2013-4 and 2014-15. The CPI rise to 5.4% in February (from 3.3% in November 2014) is largely due to effect of unseasonal rains on seasonal vegetables. The marginal decline in CPI inflation in March to 5.2 per cent supports this conclusion. The effect of

Monetary Tightening

          With a nominal Repo rate of 7.5%, Real repo rate (using PFCE inflation) was 2.5% in 2014-15. The reduction of the nominal Repo rate from an average 7.9% in 2013-14 has been too small to keep the real rate from rising from a negative -0.9% in 2013-14 to 2.5% during 2014-15. This represents a sharp 3.4% point tightening of monetary policy at a time when inflation has fallen sharply. The tightening is equally sharp if we use average CPI inflation to derive the real repo rate, which has increased from -1.9% in 2013-14 to 1.7% in 2014-15

        Even though the economy is growing at a little over 7.4 per cent as per the new GDP data with base 2011-12, this is not true of the organized sector of the economy, which is growing at a much lower rate. High real interest rates are choking off recovery of interest sensitive consumer durable sectors like automobiles and housing and also of real estate in general.  Lower interest rates are critical to faster recovery of these sectors. One indication of this is the fact that the index of motor vehicle production in 2014-15 averaged 12% lower than it did in 2011-12. GDP from (Value added in) the Construction sector in 2014-15 is projected to be only 2.5 per cent higher than it was three years earlier in 2011-12.
    

    As the labor intensive real estate, housing and construction sectors uses a lot of rural migrant labor, the poor performance of these sectors is partly responsible for the documented slowdown in rural wage growth. This, along with a slowdown in agricultural growth can also be linked to the reported softening of rural demand after several years of firm demand. It should therefore be no surprise that demand for industries such as cement and steel supplying inputs to these two sectors are also in the doldrums.

Rupee Appreciation

     The Indian rupee has appreciated by almost 10% in real effective exchange rate terms (REER36 country index). This represents an additional tightening of the monetary policy.  The timing of current and capital account liberalization should be modulated to minimize the appreciation of the exchange rate.  A faster reduction on controls on capital outflows and reduction in import protection can help moderate the appreciation of the rupee and certainly needs to be part of the policy mix.  

     However the real interest rate interest differential with global rates has been rising and is now too high. It is drawing in excessive short term capital flow and leading to real appreciation of the rupee. If there is no change in nominal rates, the ratio of short term (ST)  to medium-long term (MLT) capital inflows is likely to worsen .

      The rupee appreciation is adversely affecting demand for the globally connected, globally competitive parts of the corporate sector (worsening the demand-supply balance), which seems to be operating at 60% to 70% capacity utilization and delaying recovery of fixed investment and the upturn in the corporate investment cycle. This consists of two parts: One the Metals & Mining: With Coal and mining policy being sorted out through transparent auctions, corporate metals and mining sector is likely to recover, followed by fixed investment in the sector. Two, the rest of the globally connected corporate sector.  In this case a correction of the appreciation will lead to faster recovery of demand, profits, ROE , sustaining the shift from debt to equity initiated by the fall in real interest rates. Fixed investment revival will follow with a lag.

      The delayed recovery in the globally connected & competitive (GC&C) sector also adversely effects the recovery in excise and corporate tax collections, which are collected mostly from the large, organsed corporate sector. Consequently both the corporate cycle and the tax revenue cycle(post global financial crisis)  are lagging GDP growth recovery compared to the normal recovery cycle (pre GFC).

       A rise in US interest rates will reverse some of the rising real interest differential, but that is still more than 6 months away. The profit expectation, ROE and risk profile of the globalized part of India’s corporate sector will worsen in 6-9 months if nothing is done to reverse the appreciation.

Infrastructure

    Legacy problems in infrastructure, created partly by overoptimistic demand projections and partly by government directed lending by Public Sector Banks (without resolving difficult policy & regulatory issues) have not been resolved as quickly as necessary for speedy recovery of this sector.  They therefore continue to delay PSB (NPA) and corporate infrastructure revival in sectors such as highways. However, Central Government’s expenditure plans have begun a revival in power and railways sub-sectors.  This, along with reforms in other sectors, will also have a positive effect on corporates and banks with non-performing assets in other infrastructure sectors. 

   An obvious implication of the corporate problems outlined above is that the Banking sectors appetite for lending to these sectors is adversely affected.

Expectation Effects

     As a decline in repo-rates gives rise to expectations of debt asset price appreciation that will be reversed after the asset price appreciation, it is not sustainable after interest rates fall. Such expectations argue for sharper, quicker reductions in repo rates rather than in small steps over a long time period.

Inflation & Monetary Policy in 2015-16

  In projecting  inflation for 2015-16,  two factors are significant. First core, non-food, non-fuel inflation in March was 4.4 per cent, which was also the average of the last four months. Core (non-food, non-fuel) WPI inflation in March was even lower at -2.5%. It is reasonable to expect the gap between the two to close, particularly given decelerating inflation in transport, real estate and wages which are relevant elements between wholesale and retail markets. Thus we are already in 2015, well on the way to the 2018 inflation target of 4 per cent, at least as far as core inflation is concerned. Food inflation is currently running at around 6.1% in the CPI, but is much lower at 4.4% in the WPI, indicating that CPI food inflation is headed lower. If government focuses on agricultural reform and as promised in the budget, NITI can develop a consensus among the States, food inflation below 6% in January 2016 and 4% in 2018 is feasible. There is large gap between the CPI (4.5%) and WPI (-10.5%) on fuel inflation, because the complex system of price controls, administered prices and subsidies. However, even if there is some rise in global oil prices during the year, CPI fuel inflation is unlikely to exceed 6%. Thus total CPI inflation is likely to be between 5 and 5.5 per cent.

     Inflation as measured by the private consumption deflator or by average CPI inflation is therefore projected to decline further by about 1 per cent point. If the nominal repo rate remains unchanged, the real repo rate will increase further to 3.1% in private consumption deflator terms and to 2.1% in CPI terms. Such a tight monetary policy has not been seen since high growth year of 2007-8 when CPIIW inflation averaged 6.2% and global inflation pressures were high. Even if the nominal repo rate is reduced to an average of 6.5% for the year 2015-16, the real repo rate will be 1.1 per cent in terms of average CPI inflation and 2.1 per cent in terms of PFCE inflation, more than enough to keep pushing inflation towards the 4% target for 2017. Thus a reduction in the nominal repo rate is urgently required.

Transmission

   The argument of weak transmission of repo rate movement applies to both rate rises and rate reductions. If transmission of monetary policy signals like the repo rate is weak, a merely signaling of a change in intentions by the central bank can have little or no effect on market interest rates. The central bank may therefore need to make larger changes in the repo rate to have the same effect as in countries where markets are well integrated and efficient.

     It is also sometimes argued that monetary transmission is asymmetric in the Indian system, where ¾ of the assets are controlled by government owned banks.  To the extent that these banks are in turn controlled by risk-averse appointees of the government, part of whose time is spent on trying to minimize government pressure on lending to sub-sectors with high policy or regulatory risk and/or inefficient and failing borrowers (cronies), this has some validity.  In this situation, jaw boning by the Central bank in co-operation with the Government can be a valid instrument for correcting the asymmetry. Beyond this, it suggests that larger changes in repo rates would be required when lowering rates than when raising rates, thus introducing a down ward bias in rates.  
        Historical data indicates that as far as monetary policy managers are concerned, positive inflation surprises have historically predominated over negative ones and consequently the real repo rate has averaged a negative -2.5% or so since 2004. A balancing of these two factors suggests that a 4 per cent nominal  repo rate would be appropriate when inflation is projected to be at the long term target of 4 per cent (+/- 2%), with upward(downward) revision of repo rates if inflation surprises are positive(negative).

Conclusion

    A zero average real repo rate seems to be an appropriate long term target for the RBI, while shooting for a minimum one percent point reduction in the real repo rate for 2015-16. If inflation declines below the conservative projection of 5 to 5.5 in this note, a larger reduction in the nominal repo rate would be warranted.

----------

A shorter version of this post appeared earlier in ET blogs at  http://blogs.economictimes.indiatimes.com/PolicyAnalysis/why-a-reduction-in-the-nominal-repo-rate-is-urgently-required/