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.

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[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).

World Economic Outlook is not in Spring

Joint note with Prof. Charan Singh, IIM B

The world economy in 2013 is projected to grow by 3.3 percent, a shade lower than 3.5 percent estimated in January 2013 and marginally higher than 3.2 percent in 2012, according to the World Economic Outlook released by the IMF on April 16 at Washington DC. The world is recording a three speed recovery with strong growth in emerging markets, slow growth in the US and negative growth in the euro area. The projections for all major countries except Germany and Japan have been revised downwards. India’s projected growth is now pegged at 5.7 percent, lower by 0.2 percent from the IMF estimates released in January 2013.

The IMF hails the positive trend in growth in 2013 over 2012 and observes that though global prospects have improved, the road to recovery in advanced countries will remain bumpy. The economic activity has already picked up steam in emerging markets and is expected to accelerate gradually in advanced countries in 2013. Interestingly, IMF observes that economic activity in many economies is held back by continued fiscal adjustment (even in the US), competitiveness problems and balance sheet weaknesses.  According to the IMF, two great threats to economy recovery – break-up of Euro area and sharp fiscal contraction in the US - have been defused. But risks still remain in the short and medium term. In the short term risks are mainly from the euro area while in the medium term, the key risks are insufficient institutional reforms, weak balance sheets, broken credit channels and prolonged stagnation in the euro area; and high deficits and debt in the US and Japan. In the medium term, emerging markets need to tighten their monetary policies and strengthen prudential measures for the financial sector in face of sustained rapid growth of credit and high asset prices, if necessary.

The emerging markets have done well on the fiscal front and are expected to continue with neutral fiscal policy in medium term. The WEO observes that the growth in emerging markets may be strong but is less than projected during the last few years. These forecast disappointments are symptomatic of deeper structural problems heralding cutbacks in investments or capital outflows and need to be seriously considered by the policy makers.

The improvement in global economy could again result in substantial capital flows to the emerging economies which would require adjustments in the policy mix. IMF guides that when the capital inflows threaten to destabilize the economy, then the country can adopt capital flow management measures to avoid the buildup of major internal imbalances. Merely tightening of monetary policy could reinforce capital inflows and therefore countries with current account deficits need to consider macro-prudential measures, fiscal tightening and avoiding exchange rate appreciation.

To reduce global imbalances, China needs to have higher consumption and Germany more investment while the US needs to boost national savings through fiscal consolidation. Other deficit economies need to undertake structural reforms to rebuild competitiveness, according to the IMF.

The prices of main commodity groups, including food and oil, are projected to decline in 2013 with improving supply prospects and harvest. However, metal prices are projected to trend upwards, consistent with global recovery.

The WEO contains very interesting discussion in two specific box items. First, the discussion in Box 3.1 under the title Does Inflation Targeting still make sense with a flatter Phillips Curve is certain to gladden the heart of two past Governors of the RBI, amongst many policy makers in India. The researchers in the IMF are now beginning to realize that touting inflation targeting to all countries and in all circumstances was probably not the best policy advice. In Box 1.1, titled The Great Divergence of Policies, an unusual path of global recovery when compared with the three global recoveries is discussed. The ongoing recovery path after the great recession exhibits two types of divergences. First, recovery has been the weakest for advanced countries and strongest for emerging markets in contrast to earlier recoveries where advanced countries were the engines of global recoveries. Second, and more interestingly, monetary and fiscal policies, mainly in advanced countries, have marched in opposite directions in this recovery whereas in the previous episodes, the two policies were always aligned.

For India, a number of concerns emerge. First, the recovery in euro area and the US economy continues to be sluggish which could impact India’s exports. Second, according to the projections by the IMF, India’s CAD is projected to be 4.9 percent in 2013 and 4.6 percent in 2014 and consumer prices nearly 11 percent for both the years. While the real GDP for India is projected to rise from 5.7 percent in 2013 to 7.0 percent in 2018 that of China is projected to rise from 8.0 percent to 8.5 percent, respectively.

Global Economy: Fiscal and Monetary Policy

For the last two years (see earlier blogs)we have emphasized that credibility of fiscal policy depends more on legal and procedural reforms that will lead to a steady and sustained reduction in the fiscal deficit over the medium-long term and less on an immediate drastic squeeze on expenditures.  Even in the few cases that the latter helps establish credibility about the former, the consequent reduction in growth will inevitably undermine the short term gains and shake the presumed “anchor.” This will inevitably require a moderation of the “excessive squeeze” and undermine any short term gains in credibility.  Thus even in the short term it is better to moderate the growth of consumption expenditures and fiscal transfers and to shift expenditures to productivity and growth enhancing investment expenditures.

In deciding on the appropriate fiscal-monetary policy mix, we have to distinguish, first between reserve currency countries,such as USA and others.  In the former case, there is a danger that a large part of the monetary expansion will transfer into rise in global commodity and asset prices, rather than enhancing domestic investment.  This is further exacerbated in the case of private consumption based on consumer credit as the failure to solve the Household mortgage problem early in the post-crises period, has resulted in  a deleveraging process that is much longer and more painful than it could have been with early action. 

In other countries, we have to again distinguish between countries constrained by currency union (e.g. EU) and those not so constrained.  In currency Union countries, self imposed constraints (EU on ECB) on monetary policy have exacerbated the crises.  Monetary policy was much tighter than it should have been. The recent loosening of monetary policy, has gone about half way to correcting the problem.  This process needs to be continued if the fear of contagion within the currency Union is to be eliminated.  The fiscal situation that matters in this case is the overall fiscal position of the currency Union, which is adequate to allow for a substantial further easing of the monetary policy approach, provided the debt of the insolvent countries is written off and all countries with tenuous fiscal situation make fundamental changes in their expenditure and tax policies to ensure future sustainability.

Will China Eclipse the USA and Dominate the World?

Virmani (2005), concluded that "the (current) unipolar world will be transformed into a bipolar world during the first quarter of this century and into a tri polar one (China, USA, India) during the second quarter of the century."  This was based on construction of a simple new Index of Power Potential (VIPP), which took account of a country's size and technological competence measured succinctly by per capita GDP, and projection of the underlying economic/demographic variables.  These projections have been updated and refined in a series of subsequent papers and books(2006, 2009).*  My latest projections for VIPP indicate that China's Power Potential (or economic power) will equal that of the USA around 2025 and exceed it by 2030, while India's will attain the US level around 2045.  Does this mean that China will 'Eclipse' the USA or Dominate the World? Not necessarily, for two reasons.
   Firstly my analysis of the Cold War period, based on the same index, shows that at the peak of its power in the 1980s the USSR had about 25% of the power potential (VIPP) of the USA. Yet the World power structure was Bipolar and considered by everyone to be so.  Second overall power depends both on economic power and Strategic power (strategic technology and assets, including arms, nuclear and aero space) which have to be factored in to get an index of overall power (VIP).  Though China will eventually catch up with the USA on this front this will happen at least a decade or two after it equals the USA's economic power.  Based on these three factors, I conclude that the World's power structure is likely to  become Bipolar, with two superpowers  (USA-China) around 2025 and to become tri-plolar, with three super powers (US, China, India) around 2035-40.
    The greater uncertainty about the latter arises from a fourth ingredient in global power. The motivation of the country (its intellectuals, government, politicians), to obtain and use global power (the 'Will to Power").  Both the USA and China have this 'will' as did the USSR, and therefore the US will eventually do all in its power to maintain its strategic lead, not least by resisting by countering China's strategy of acquiring technology by every conceivable means.  On the other hand it is not clear that India has this global motivation!  If it develops the 'will' then India will become a 'super power' by 2035, if not then it may not happen till a decade later.
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*See earlier blogs or  https://sites.google.com/site/drarvindvirmani/