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.

Current Economc Situation

Some Answers to Questions posed by Bloomberg on the Current Economic Situation:

Q1: We have rates tightening coming in the US, while ECB and BOJ are easing policies. How do you see these diverging monetary policies impacting the the rupee?

A1:The US$ has been appreciating against all currencies as result of higher growth expectations and expected rise in interest rates relative to Europe, Japan etc.. It has consequently appreciated by around 12% against the index, but only about 5% against the rupee. So the Rupee is quite comfortably placed.

Q2: What's your outlook on the rupee? Where do you see the rupee by the end of Dec. 2015? Also, pls mention the reasons that will be influencing the rupee in 2015?

A2: This depends on the further changes in the USD against the other currencies. However, one is reasonably confident that the USD appreciation against Rupee wont be larger than against the index. Though there is great uncertainty about oil prices, at some point in the next two years they will rise & have some impact on our CAD

Q3: On balance, how do you think the RBI will respond to evolving situation? 

Will it keep the rates high to defend the rupee amid financial markets volatility or due you think it will cut rates going forward to support growth?

A3: I cannot speculate on RBI's response. I believe that the relatively lower depreciation of the Rupee against the dollar, as indicated in A1, and the down trend in Indian inflation (through its effect on real exchange rates), provide additional leeway to cut Indian interest rates.

Q4: What's your outlook on the RBI's monetary policy? Do you think, it should cut rates now since CPI inflation has come down, while growth still remains tepid?

A1: The time for a rate cut arrived several months ago with the dramatic change in inflation trends. Every piece of new inflation data has reinforced my earlier conclusion that it is time to cut rates.

Q5: When do you think the RBI will start cutting rates? What is it that the RBI is waiting for to cut rates?

A5: The RBI seems to have three reasons for not cutting rates last month. A slow downward adjustment in inflation expectations, uncertainty about future inflation shocks and the need to avoid the discomfort of having to raise rates in next year or two after reducing them now. This view was supported by financial market participants who believe in Chicago-Wall street monetarist approach & the IMF. At some point the sharp downtrend in inflation will force them to change their view, resulting in monetary loosening

Q6: What's your outlook on the Indian economy in fiscal year to March 2016? What factors you think will be driving growth?

A6: I had forecast a 1% rise in the growth rate for 2014-15 (over 2013-14: ie 5.7%) with a margin of 0.25% on either side. The delay in loosening monetary policy will likely push growth to the lower end of my range of 5.45% to 5.95%). Growth in 2015-16 is still likely to reach the 6.5% to 7% range that I had given after the June 2014 budget, because of the structural reforms underway and the likely change in macro policy (macro twist) to tighter fiscal policy (lower Revenue deficit) and looser monetary policy (lower repo rates).

Q7: What's your outlook on the government's efforts to reduce the budget deficit? (do you think, it will succeed in containing budget deficit at 4.1% of the GDP in Fy15 and 3.6% in Fy16)?

A7: After the June budget I had said that despite the difficulty of attaining 4.1% FD, the FM would likely have to achieve it to establish credibility. This is still the most likely outcome. I also believe the FM will stick to the targets for next year. There are some voices that are urging a weakening of these targets to stimulate growth through higher investment. In my view this would be a serious mistake. The best way to stimulate investment is to reduce Revenue deficit to zero and use the space created to increase real infrastructure investment within these fiscal deficit targets.

Q8: How do you view the drop in global crude oil prices and how will it impact inflation, budget deficit and the cad in India?

A8: The decline in crude oil prices has clearly helped in reducing inflation, the CAD and oil related subsidies. But we shouldn't forget that it also indicates a lower than projected World growth & and growth of global demand. This is part of the reason for slower recovery of manufacturing sector world wide and in India, which is also reflected in  lower revenue growth.

Other Questions:

Q9: How much of a drag will the World economy be on the Indian Economy.

A9:   There are two aspects of this issue. One is that an analysis of the acceleration in the growth of the Indian economy and the World economy from the early 1990s and subsequently in the early 2000s and the negative impact of the Global financial crisis shows that in per capita terms India's economy slowed by about 3.6% while the World economy slowed by 1.2% (in per capita real growth). Thus at 2.4% or 2/3rd of the deceleration is due to domestic factors and can be reversed.
     Given the preceding boom and the continuing high investment in China the excess capacity in manufacturing and mining continues. This continues to put strong competitive pressure on manufacturing recovery in India and across the World (Ultra globalised sectors). However, there is scope within every sub-sector and industry to improve investment in and output of intermediate quality goods which are less globalised and less subject to global competition.

Q10: Some people have called for an easing of monetary policy, others have called for an easing of fiscal policy to increasing government expenditure on infrastructure. What do you think.

A10: In my view the best macro policy for India at this time is an easing of Monetary policy and a strict adherence to the fiscal deficits targets. In fact Government should go further and reduce the Revenue deficit further to zero, the original FRBM target for revenue deficits: In other words the government should shift its expenditures more sharply from subsidies and consumption/current expenditures to infrastructure investment, while sticking to fiscal deficit targets [ http://dravirmani.blogspot.in/2013/02/macro-pivot-rebalancing-of-indian.html , http://dravirmani.blogspot.in/2013/08/managing-indian-macro-pivot-twist.html ]
   As in the case of Indian States so is the case for different countries- One size does not fit all. What is the best policy for Europe, namely an increase in fiscal deficit through greater expenditure on infrastructure investment, is not the best policy for India. India needs monetary easing as real interest rates have increased sharply during the last 6 months or so because of a sharp decline in trend inflation [  http://www.btvin.com/videos/watch/10117/rajan-called-for-a-%27make-for-india%27-policy-over-%27make-in-india , http://www.youtube.com/watch?v=vL7voeGkMvQ&feature=youtu.be   ]