India-China Growth Reversal & GDP Gap

Introduction

      The long anticipated deceleration in rate of the growth of China’s economy is under way. Even normally conservative World Bank and IMF, are confirming that China’s growth is slowing down and is likely to fall below 7%.  Even those analysts who had forecast a deceleration in China’s growth were unsure about when exactly the slowdown would start. The author had estimated in the 2000s that China’s growth would decelerate below 8 per cent, around the middle of the decade starting 2010.  The global financial crisis of 2008 sharply raised the probability that the slow down would occur within the following decade, despite risky efforts by China to prop up growth.

      In contrast India was forecast to achieve its potential growth rate of about 8 per cent, given its Export-import neutral growth model. The surprise in India’s case was the sharp slowdown from 2011-12, largely attributed to complacency and domestic policy mistakes. Despite these mistakes, however, India’s growth rate from 2002-03 to 2013-14 was among the ten highest in the world (using the old data series).  Though, the correction of these mistakes, may no longer be enough to restore growth to earlier levels, India can and must restore growth to the average rates achieved earlier. Again, this has been recognized by both the World Bank and the IMF.     These two developments taken together, imply that India trend growth rate is poised to  exceed that of China’s in the next few decades.

GDP Levels vs Growth rate

    This will start the long, slow process of closing the GDP gap with China, which was 1.4 times India’s real GDP in 2013.  There is a common tendency to confuse relative levels of GDP with growth rates, so it is important to understand that China’s real GDP, measured at Purchasing power parity in 2011 international dollars, is now 2.4 times that of India's GDP. China's GDP PPP was 1.1 times India's GDP PPP in 1990, with the two economies almost equal in size in the mid-1980s. During 1990 to 2013, China's growth averaged 9.9% per year, 3.4% points faster than India’s average GDP growth rate of 6.5%.  Even if the growth differential was inverted and China's GDP henceforth grows an average 3.4% points slower than India's GDP (say 5% - 8.4% = -3.4%),  it would take 30 years to eliminate the GDP gap, about the time it took to open it.

Previous Growth Forecasts

    The basic theory and empirics of growth, show that fast growing economies like Japan, S Korea, Singapore and Thailand, which grew fast when they were at low or middle income levels of per capita GDP, maintained growth at high levels for one to two decades and then slowed down as their per Capita GDP approached that of the (lower end) of the High Income economies.  The surprise in the case of China was that it maintained an average growth of almost 10% for thirty years, despite reaching middle income levels of per capita GDP about a decade ago.  Many analysts, whose predictions about China's growth slowdown had been proved wrong in the 1990s, became much more cautious thereafter. Those of us who were willing to take a reputational risk, have been proved right, as China’s economy slowed below 8% in 2012 and is now projected to slow below 7% by the multilateral institutions.

    The global financial crisis ensured that growth of World trade would slow sharply below the very high growth seen in the previous decade, aided by a correction of the bubble like growth seen just prior to the crisis.  This meant that China’s (net) export-investment model was no longer sustainable and would produce slower growth in the 2010s.  To delay this slowdown China pumped large amounts of credit into the economy, with the official Debt-Gdp ratio rising from 55.2% of GDP in 2008 to 88.1% in 2013, an average increase of 6.6% points of GDP per year. Analysts have estimated that the debt in the shadow banking system may have increased by an equivalent amount, with total debt rising to dangerously risky levels.  Based on historical experience of such debt bubbles, some analysts predict that this bubble is now likely to burst and reduce China’s growth rate to the 3% to 4% range. Analysts who have greater confidence in the ability of the Chinese Communist party to manage economic crisis, nevertheless predict a deceleration of the trend rate of growth to a range of 6% to 7%. A safe intermediate prediction is a gradual growth slow down to 5 to 6 per cent rate over the next 10 years.

Comparative Growth

   Based on World Bank, World Development Indicators data till 2013 (till which year India's GDP base 2004-5 was fully available), we can examine and compare the growth rates of China & India. A plot of these rates shows that the growth rate difference has been narrowing since 1990, due to a gradual deceleration of China and a stronger acceleration of India. Underlying this narrowing growth difference are variables that are drivers of or correlated with, GDP growth and productivity. These include FDI and exports, which are indicators of competitiveness and Imports which reflect openness.

     The difference between China and India’s FDI-GDP ratio has been on a declining trend, from about 3.5% of GDP in 1990 to a little over 2% of GDP in 2013. Underlying this is slow but steady progress in attracting technology and risk capital to India, with a milder decline in China’s attractiveness. China’s Export GDP ratio which was 8 per cent points higher than India’s in 1990, rose 10% points to an average of 18% during 2005 to 2007. It then narrowed rapidly to about 1% in 2013, indicating that India’s exports have held up to the global decline in world trade since 2008, much more effectively than China’s. The difference between China and India’s Import-GDP, which fluctuated around an average of 7.1% points between 1990 and 2007 declined dramatically to -5.2% by 2011-13, indicating that the Indian economy is now significantly more open than China’s.

Base Change Implications

       Analysis and forecasting of Indian growth has been confounded by the appearance of a new GDP series (2011 base) which has made some fundamental changes in methodology and data sources used.  As this new series provides less than three years of growth data it is impossible to estimate the underlying trend growth rate using this series.  After the mid-year 2014 budget I had written that “The measures taken in the budget will be sufficient to increase growth by about 1 per cent point over the last year’s 4.7% to 5.7%. Actualization of some of the measures indicated in the budget will however be necessary to raise growth to the 6.5 to 7% range in 2015-16.”  Given that the average growth rate as per the new data is about 1% point above that, using the new data, a projected growth rate of 7.5% to 8% is quite conservative. This seems to be the reasoning underling the World Bank’s and IMF’s  projections for India’s growth in 2015 and 2016.

      The CSO has however projected a growth rate of 7.4% for 2014-15 and a growth acceleration to 8% in 2015-16 would not be wildly optimistic.  As many observers have pointed out however, high frequency data, such as the Index of Industrial production for manufacturing, quarterly results for companies and tax revenues from excise and corporate income tax, do not appear consistent with these high growth levels. The author has argued in the policy paper, “Indian Growth Puzzle,” ( Policy Paper No. WsPP 3/2015, New Delhi, April 2015 ) that the global financial crisis (GFC) and the consequent global demand recession and excess capacity, have affected not only the export led Chinese economy, but also the globally competitive and connected corporate (GCC) sector of India. Post GFC, the GCC corporations will lag overall recovery, instead of leading it, as they did in 2002-3 to 2007-8. Thus all indicators connected with these companies, such as IIP, corporate profits, corporate & excise tax revenue would also lag the GDP recovery. The Indian Government needs to be aware of this issue and be prepared to manage central government expenditures subject to a slower recovery in tax revenues.

Conclusion

    Based on the theory and empirical evidence provided by high growth economies, some analysts had predicted since the 2000s, a slowing of the Chinese economy during the decade of the 2010s to rate of growth below that of the Indian (“China-India growth Projections” and other papers at https://sites.google.com/site/drarvindvirmani/growth).  By making the export-investment led strategy of development unviable, the global financial crises made this highly likely if not inevitable. It was also assumed in the forecasts that the Indian government would continue to carry out the minimum reforms necessary to maintain India’s growth rate at an average of the previous decade. Because of complacency and policy mistakes by the Indian Government between 2010 and 2012, the Indian economy, faltered seriously. The corrections introduced in the last two years, have restored some of the momentum.

    Sustained growth of 8 to 8.5% over the next few decades, however requires implementation of the reform agenda and continuing sensitivity to shocks that can derail growth, given that the World environment is far from conducive to sustained high growth.  If this is done we should expect to see India growing faster than China and beginning to close the wide gap that has opened between the per capita GDP of the two countries. This has implications for China and India's foreign policy towards each other, that need to be kept in mind. Given the wide Gap between the GDPs of the two countries, it is however, likely to take at least 30 years for India to eliminate the GDP gap with China.

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A version of this article appeared as the Lead article in The Hindu dated 29^th April 2015 under the banner. "Tracking Two Growth Stories" :

 http://www.thehindu.com/opinion/lead/india-and-china-tracking-two-growth-stories/article7151377.ece

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.

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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/