Real GDP, Interest & Exchange rates in a Dual Economy

In listening to US Ivy league trained economists, it strikes me that they have either forgotten what they learnt in college and preached on Wall street for 20 years or have been so traumatized by the Global Financial crisis, that they have forgotten that real economy is about real interest rates and real exchange rates!

Some analysis to remind them: Indian real interest rates have risen sharply during 2014-15. This has had a negative impact on interest sensitive sectors like real estate & housing and Motor vehicles. 

   By increasing the interest differential with the World, this (incentivizes &) leads to short run capital inflows. This has led to an exchange rate appreciation of 10% in 2014-15, despite the fact that part of inflows has added to exchange reserves and despite a fall in inflation which would normally result in real depreciation. The real appreciation has had a strong negative effect on the tradeable sectors of the economy, particularly the globalized corporates sector, which has slowed recovery from a cyclical trough.  Though this sector’s growth recovery is affected by the speed of Global recovery(ie of globalized sectors world wide), misplaced Indian policy has nipped the incipient recovery in the bud.  

  Meanwhile fiscal policy has moved in a mildly positive direction, with a slightly lower deficit and a slightly higher ratio of investment to consumption. With the exception of one serious error on the taxation issue (MAT), reform policies have seen moderate to good progress.  One has therefore to attribute most of the above effects to a hardening/tightening of (real) monetary policy during 2014-15 (by about 2% points). It follows that at a minimum, the (real) monetary tightening must be reversed in 2015-16 and a greater effort made to reduce government consumption (leakages) so more can be spent on infrastructure investment. This will stimulate growth without affecting inflation.

 Purely Indigenous analysts (as against ivy league ones), seem on the other hand to have forgotten that the organized part of the economy is not the whole economy, but just a fraction of it.  Till a decade ago they talked about the dual nature of the economy and how monetary and credit policy actions of the central bank affected only the formal organized part of the economy.  Even though the globalized part of the economy and the formal financial system has gradually increased since 1990, the economic and financial dualism hasn’t suddenly disappeared or become irrelevant. Thus monetary and credit policies affect mostly the formal economy.  Growth of the informal economy can be faster or slower than the formal and its relationship to monetary policy is obscure at best.  

  Because the 1990s reforms unshackled the formal, organized part of the economy, it invested more and grew faster than the informal part of the economy. Post-financial crisis, global trade and GDP growth collapsed. Consequently, except for 2009, when there was a world wide injection of fiscal and monetary stimulus, we should not be surprised to see the formal, globalized part of the economy growing slower than the informal.   In fact the continuation of the Indian stimulus in 2010 made the subsequent downturn worse.  

An interpretation based on a pure dualistic, segmented financial market model of the Indian economy would suggest that monetary policy tightening has reduced demand and capacity utilization in the formal sector and pushed it towards deflation (as indicated by the IIP and WPI respectively), while the informal sector has recovered gradually despite changes in monetary and fiscal policy.   The actual picture is undoubtedly a little more complex than either the Wall street-Chicago model or the Dual economy model can capture. That is why good macro-economic practice, requires a mixture of theory, empiricism and intuition.

National Reform Agenda: Post Modi 1 year Update

Introduction

My January 2014 paper titled “National Reform Agenda for Growth and Welfare” proposed a reform agenda for the five years of the Government that would be formed after the General Election in May 2014.[i]  At that time, a number of pre-election Pols predicted that the BJP-NDA could be the largest party-coalition in the Lok Sabha, there was far from consensus on how far they would be from a majority. Thus the paper can be taken as an objective assessment, given the data and information available till that time, on what needed to be done. 

    A recent paper, titled “National Reform Agenda: Year One of Modi Government,” by the author, Evaluates the actions taken on the issues reaised and suggestions made in the January 2014 paper.[ii] There were three main sections in the Agenda(January 2014)[iii]: The Broad Objectives and aims, Reviving Growth by correcting the mistakes made in the previous four years, with particular reference to Governance, and Economic & Institutional reforms for putting growth on a sustained fast growth path. The paper, uses the same format and headings as in the earlier note, and considers each of the 15-16 sets of issues and suggestions. In each case the action taken by the Modi government is listed and commented on, followed by further suggestions. The first broad suggestion and the conclusions are reproduced here to give a flavor of the paper:

Objective: Closing Welfare Gap

Issue: Welfare Gap It is the gap between our per capita GDP (at PPP) and the World average, which (along with corrupt governance systems) results in our having higher poverty ratios and worse social welfare indicators than those of better off countries. The fundamental objective of any Indian government must be to close the welfare gap of the Indian people with the rest of the World.  This will require a restoration of per capita growth to 6.5% (~ 8% GDP growth) and policies to sustain this growth rate.  If we can sustain such growth for two and a half decades, Indian welfare levels will equal the rest of the world by 2040.

Action Taken: This government seems to understand the critical link between economic growth, employment generation and public welfare. This is reflected in the change in focus from “poverty alleviation” to “poverty elimination” and economic & technological development and employment creation as the principle instrument for achieving it. Another indicator is that it has adopted, as its principle foreign policy objective, the need to close the economic and technological gap with the rest of the World.

        The other issues and suggestions range from reform of laws passed in the last few years, to Governance and corruption issues and Policy and Institutional reforms to put economic growth on a sustained low inflation fast growth path. (for details see policy paper).

Conclusion

 The January 2014 paper suggested that, “It is not necessary to accomplish all the listed reforms within three years, though it may be opportune to take the politically sensitive steps within the first few years.  It is however essential to outline the broad direction of reforms and to take credible steps to implement them.”

  The government has taken action in virtually all the areas suggested by the paper. Thus we can say that it has taken credible steps to implement the suggested reforms. There are undoubtedly a few areas in which action has not been initiated, but this is to be expected from any government. Good progress has been made in a majority of areas, with one exception. The performance on income tax reform issues has been dis-appointing.  Government has, however shown responsiveness by responding quickly to widespread protests on what were seen to be backward steps.

   Inflation has declined sharply from 11% in Oct-Dec, 2013 to 5.3% in Jan-Mar 2015 (CPI2012). Both food (weight 0.39) and Core (weight 0.54) have contributed to this decline, with food inflation down from 14.7% to 6.4% and core inflation from 8.7% to 4.5%. CPI Fuel (weight 0.68) inflation has actually risen from 1.6% to 2.3% because of lags in pass through.

  Economic Growth has accelerated by 0.4% to 0.6% in 2014-5 relative to 2013-14: 0.4% in the case of GDP which approximates what was earlier called GDPMP and by 0.6% in terms of Gross Value Added(GVA) which approximates what was earlier called GDPFC. This is a little lower than what the author had projected, based on the old GDP series.[iv] However, the decline in Inflation is much greater than any analyst (including the author) had forecast. Thus inflation as measured by the Private consumption deflator has declined from 8.5% in 2013-4 to 4.6% in 2014-15 and inflation as per the CPI2012 base has declined from 9.5% to 6.3%. The global factors that have aided the fall in inflation are the same ones that have slowed the recovery of World GDP and World demand for tradable goods and services and thus contributed to the slower recovery of the Globalized part of the Indian Corporate sector.  Thus to the extent that success in inflation control can be attributed to global developments, the same developments also resulted in slower recovery of GDP growth. 

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[i] Virmani, Arvind, “National Reform Agenda for Growth and Welfare,” Policy Paper No WsPP 1/2014. https://sites.google.com/site/drarvindvirmani/policy-papers   

[ii] Arvind Virmani, “National Reform Agenda: Year One of Modi Government,” Policy Paper No. WsPP 5/2015: https://sites.google.com/site/drarvindvirmani/policy-papers

[iii] Virmani(2014) op cit FN 1.

[iv] We had projected an increase of growth rate of GDPFC of 1% +/- 0.25 ie between 0.75% & 1.25%. Thus the actual increase in GVA is a little below this range.

PM Modi's Foreign Policy: An Update

  A recent Policy paper (WsPP 4/2015) analyses the changes in foreign policy under PM Modi’s government. Here are some excerpts from this paper giving a flavor of the issues and arguments [i] :

     The most fundamental change in Foreign policy, is the one referred to in October 2014 as “India First.” [ii]   The choice of words was perhaps not the most diplomatic, but the implications remain the same and are amply supported by subsequent developments.  One of the achievements of the previous NSA was to bring out a foreign policy paper titled “Non-alignment 2.0” i.e. the 21^st century version of the post War (WW II) foreign policy of “non-alignment” between the two poles of that time, USA and USSR.  By definition, Non-alignment starts with a definition of the “poles” or countries and their policies, between which one is non-aligned.   “India first” turns this approach on its head, by defining India itself as one of the poles, with a clear set of domestic and international objectives and expectations from other countries.  Instead of looking first at what other country’s objectives and expectations are, and  weaving our way through the contradictory objectives of other poles, we as a fixed pole, first define our own objectives and our expectations from other countries, including the “poles.” We then try to convince them to support our objectives, making whatever bargains necessary for achieving these objectives. 

     An essential element of this changed perspective, is the new government’s “pragmatic actions and ‘view of the world,’ ”  Therefore there has been a search for deals with every pole to further India’s  “primary objective of closing the economic and technological gap and building national power, in a pragmatic forward looking manner jettisoning ideological blinkers and minimizing historical baggage(Oct2014).”  This is neither ‘non-alignment 3.0’ nor ‘multi-alignment’, but the first step in the “Multipolar transition to a Tri-polar world” in which India will be one of the three leading poles by 2020, albeit the weakest of the three.[iii]  India in 2013 ranked third behind USA and China in terms of size of GDP at PPP and tenth behind Russia (9^th) in terms of current dollar GDP. Its economic power, as measured by the VIPP index of potential power, was six.[iv] Author’s projections indicate that India’s rank will rise to number three by 2020. The Modi government’s aspirations of India becoming a ‘leading power’ not just a ‘balancing power,’” as outlined by the foreign secretary, reveals an appreciation of the emerging possibilities.

   Some analysts have called India’s new foreign policy approach as ‘multi-alignment.” But this is a misnomer, because India is not aligning either with the sole super power USA or with the fast rising great power China, nor with the Great powers of the past (Japan, Germany, Russia, France, UK).  It’s a “multipolar transition” because the relative position of these powers, with different strengths and weakness, is undergoing rapid change.  India is on the way to equaling and/or excelling them in certain dimensions, while still being in a position to benefit from their historical strengths.   This uncertain world, with the old equilibrium slowly crumbling, but a new one could take two decades to emerge, can be characterized as a multipolar transition.

   In October 2014, there were five areas in which I saw an emerging change in foreign policy: "The centrality of economic & technological development, the integration of domestic and foreign policy with respect to this objective, the emphasis on “national power” including “military power” and “Soft power” and a reduction in self-imposed constraints on actions that third counties may construe as inimical to their interests.”[v] These changes are now clearly underway.

  The policy paper argues that, (a)  Relations with USA have taken a decisive strategic upswing, but could grow even faster if the USA understood India’s limitations of low per capita income and high poverty and acted with more generosity, given these limitations. (b) That India is moving towards a policy of “symmetry” viz China, and (c) India is adopting a two pronged strategy toward Pakistan, based on a hard headed understanding of the deep state and its actions.  Further details can be seen in the policy paper (WsPP 4/2015).

 

   “The PM Modi led Indian government is changing the emphasis of India’s Foreign and National security policies. Elements of this change in approach are already visible. These involve a clearer definition of Indian interests (“India First”) in terms of economic and technological development, a greater focus on these goals in foreign policy and a consequent integration of domestic and foreign policies. Other changes involve a greater focus on the development of national power, in particular an enhancement of the somewhat neglected element of military power, its broader definition to include asymmetric warfare of which State financed-directed non-state actors are a dangerous part, and a jettisoning of self-imposed constraints of ideology and misplaced fear of offending other countries who display no such squeamishness in their behavior.   Overall a much more confident, credible and effective national security-foreign policy is predicted to emerge over the next five years.” [vi]  These have been rapidly operationalized over the year.

   A philosophical under pining cum broader direction for India’s new foreign policy is also emerging.  This is implicit in the government’s formulation of India going from being a “balancing power to a “leading power.”  The government plans to pursue a policy that accelerates the development of India to the position of the third most powerful economy in the World. It will also attempt to raise India’s rank in  strategic-military power, an effort that is more difficult, time consuming and costly, and therefore can benefit greatly from help from super power USA and other historical Great powers like Russia, France, UK, Japan and Germany.[vii]

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[i] Virmani, Arvind, “Foreign Policy Under PM Modi”, Policy Paper No. 4/2015, New Delhi, May 2015. https://sites.google.com/site/drarvindvirmani/policy-papers

[ii] “Foreign Policy under Modi: http://dravirmani.blogspot.in/2014/10/indian-foreign-policy-under-modi.html

[iii]  Virmani, Arvind, "A Tripolar Century: USA, China and India," Working Paper No. 160, ICRIER, March, 2005. http://www.icrier.org/page.asp?MenuID=24&SubCatId=175&SubSubCatId=233. And other papers at https://sites.google.com/site/drarvindvirmani/india-great-power .

[iv] See for instance, Virmani, Arvind, "Fall and Rise of India", Working paper No. WsWp 1/2013, October 2013. https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnxkcmFydmluZHZpcm1hbml8Z3g6M2E0ZTNiNmVhYjA3MTM1Mw and other papers at  https://sites.google.com/site/drarvindvirmani/india-great-power .

[v] Foot note 1 op cit.

[vi] Foot note 1 op cit.

[vii] For details see policy paper at https://sites.google.com/site/drarvindvirmani/policy-papers