July 5 was a major event day for the world?s economies. The ECB cut rates by 25 basis points, the Bank of England expanded quantitative easing and China surprised everyone by a 31-basis-point cut in its lending rate to 6%, and a cut in deposit rates to 3%. This coordinated monetary easing was conducted both by economies growing at a very slow pace (eurozone and England) as well as an economy growing at the fastest pace in the world (China). The latest industrial production data for China is a growth of 10%, and latest inflation data is at 3%.
Meanwhile, in that other fast-growing economy in the world, India, talk is of animal spirits, decreasing red tape, reducing the fiscal deficit, cutting subsidies, and yes, making India more business friendly. Note the contrast?very few analysts in India are talking of a necessary condition to get India moving, namely a cut in our oversized levels of real interest rates, and everyone in the world outside India is talking of reduction in interest rates to propel growth back to near normal, let alone normal.
Why is India so different? A large part of the explanation lies in the beliefs of its policymakers, past and present. For example, in the latest policy statement of June 18, RBI stated: ?Our assessment of the current growth-inflation dynamic is that there are several factors responsible for the slowdown in activity, particularly in investment, with the role of interest rates being relatively small. Consequently, further reduction in the policy interest rates at this juncture, rather than supporting growth, could exacerbate inflationary pressures.?
Though a policy statement is not expected to provide either a theoretical or empirical backing of its assertions, it nevertheless is expected to have some such support, albeit one lurking in the background. The RBI policy statement accepted that growth had slowed to exceptionally low levels, that headline inflation remained inflated, and concluded that a cut in interest rates would increase inflation without improving investment. So if symmetry holds, as it should, an increase in interest rates would not hurt investment (?relatively small? effect) but would have a disproportionately large effect in reducing inflation. Which is precisely what RBI has been doing for the last year and a half?with the result that both investment and growth have collapsed, and inflation has not moderated. So the RBI policy statement is not supported by either reality, or logic.
Perhaps the RBI action of keeping interest rates high was motivated by its observation (and conclusion) that ?one implication of the rupee depreciation over the past several months is that domestic producers have gained in competitiveness over foreign producers. Over time, this should result in expanding exports and contracting imports, thus acting as a demand stimulus?. This is a correct observation, and deduction. Hence, the RBI logic may be expressed as follows?we need growth to accelerate, rupee depreciation is providing that, interest rates don?t really matter for investments and growth, so let us not reduce interest rates.
Along with RBI, some investment bank analysts have also been touting the large expansionary effects of rupee depreciation?indeed, one analyst confidently asserts that a 10% nominal effective exchange rate depreciation ? over the last 3 months has been equivalent to 100 bps of rate cuts.? But given the rupee has recently appreciated by 6%, I guess the expansionary effect is reduced to only 40 basis points! It is nobody?s case that a real depreciation of a currency is not expansionary; but it is everybody?s case that the empirical assertions be vetted, especially when our policymakers seem to be blindly accepting such calculations.
Proof should be required; both assertions?interest rates do not affect growth and real devaluations have a large effect?were rigorously tested in a 2010 paper* and results are presented alongside the chart. Interest rates are represented by a one year lag of the SBI prime lending rate (deflated by the GDP price deflator) and one year lag of real currency depreciation by an index presented in Bhalla (2012). Growth as a function of interest rates and currency depreciation yields the following strong results. Both are significant contributors to growth.
The impact of interest rate is an increase in GDP growth of 0.44 percentage points (ppt) for each 100 basis points reduction in interest rates. Lending rates have averaged close to 13% the last few years, a period when inflation (GDP deflator) has averaged 7%. This yields a real lending rate of 6%, a level double that prevailing in China. The impact of real exchange rate depreciation is -.015 i.e. each 10% sustained real depreciation in the rupee leads to an increase in GDP growth of 0.15 ppt. Therefore, at best, the equivalence of a 10% depreciation is a 35, not a 100, basis point reduction in interest rates.
The empirical reality is actually worse for RBI, and by inference, the Indian economy. RBI?s own effective exchange rate (trade weighted effective exchange rate for 36 countries, TREER36) is not significant at all in explaining growth. Second, a 10% sustained depreciation in TREER36 has not happened to date, at least since 1994; further, there is only a 25% chance that a real depreciation of 4% will be sustained for long. Third, the currency depreciation measure used in the computations (see Bhalla (2012) for details) shows an appreciation of 8% since 2009 and zero change for the last two years.
One important reason for higher GDP growth in China is that their real interest rates are half those present in India. Even back of the envelope calculations are better than hasty conclusions derived from elevator economics (this went up by 5%, and that went down by 2% etc). And there is no substitute for analysis, however difficult, based on causality rather than correlation.
The author is chairman of Oxus Investments, an emerging market advisory firm; comments welcome at surjit.bhalla@oxusinvestments.com