Rate cuts will not widen CAD

Duvvuri Subbarao

India clocked an average growth of 9.5% in the three-year period before the global financial crisis (2005-08). For a nation that once believed that the ?Hindu Rate of Growth? was its destiny, this remarkable growth performance was cause for celebration. It was also a trigger for setting off an aspiration for double digit growth. Today, there is a sharp reversal. Growth has decelerated, inflation is still high and stubborn, the investment rate has declined sharply and the external sector is beset with a record high current account deficit. This downturn has caused widespread anxiety that we may have got derailed from the high growth trajectory. It has also raised a number of questions. Is our growth story faltering? Has India?s potential growth rate declined? Are the growth drivers that worked our way during 2003-08 still intact? Has the world lost confidence in India?s growth promise? When will we reach double digit growth, and what indeed should we be doing to get there?

My short answer to all these questions is that the India growth story is still credible and that the long-term growth drivers are still intact. If we do the right things, we can get back on a high growth trajectory. Equally, there is nothing inevitable about the India growth story. We can accelerate growth and improve welfare only if we effectively implement wide ranging economic and governance reforms. Slipping up on this will amount to a costly and potentially irreversible squandering away of opportunities.

The Government has to be at the centre of this and lead the process of economic revival. As the central bank and as the regulator of large segments of the financial sector, the Reserve Bank too has an important role to play in this. What I propose to do today is to discuss some important macroeconomic challenges from the Reserve Bank?s perspective.

Managing the growth-inflation dynamics

* Growth

The global financial crisis affected virtually every economy in the world, and India was no exception. But we recovered from the crisis much sooner than even other emerging economies. In the crisis year of 2008-09, growth dropped to 6.7%, but it recovered smartly thereafter. In fact, in the two years after the crisis, 2008-09 and 2009-10, growth averaged 9% which compares favourably with the average growth of 9.5% in the three years before the crisis. However, last year, 2011-12, growth moderated to 6.2%, and the first advance estimates suggest that growth this year may drop further to 5%, the lowest in a decade.

To understand the latest down-trend, it is important first to understand the pre-crisis growth surge. Several explanations are offered for India?s growth acceleration in the pre-crisis period: the impact of economic reforms of the 1990s; India?s rapid integration with the global economy; rise of entrepreneurism; and increase in productivity.

Underlying all these factors was the massive increase in capacity as investment jumped from 26.9% of GDP in 2003-04 to 38.1% in 2007-08. This increase in investment was financed by growing domestic saving, and was accompanied by an increase in productivity driven by improvements in technology, organisation, financial intermediation and external and domestic competitiveness. The current account deficit (CAD) during this period averaged just 0.3% of GDP, suggesting that the contribution of foreign savings to domestic investment was relatively modest. But to the extent foreign saving came by way of foreign direct investment (FDI), it raised the productivity of overall investment and resulted in higher exports.

So, what explains the downturn in growth over the last two years? The answer would be a slowing of demand across the board. Private investment decelerated sharply, in part reflecting the global downturn, but largely owing to domestic factors. Business profitability was dented by tightening infrastructure constraints and increasing input prices stemming from high food and fuel inflation. Business confidence was hit by a rising fiscal deficit, vacillating commitment to reforms and governance concerns, all of which dampened investor perceptions on returns to investment.

On top of the decline in private investment, private consumption demand, which was the bulwark of the quick recovery from the crisis, too started slowing in recent years, exacerbating the growth slowdown. It is estimated to have slowed to 4.1% during the current year, down from an average of 8.3% in the previous two years.

* Inflation

Just as India recovered from the crisis sooner than other countries, inflation too caught up with us sooner than elsewhere. Inflation, as measured by the wholesale price index (WPI), went briefly into negative territory for a few months in 2009 but started rising sharply thereafter, clocking a peak rate of 10.9% in April 2010. Average WPI inflation was 9.6% in fiscal year 2010-11, 8.9% in 2011-12 and 7.5% during the first ten months of 2012-13. The story therefore is that at 8.7%, the average inflation over the last three years has been higher than the average inflation of 5.4% during the previous decade (2000-10). Both supply side and demand side factors have contributed to the buildup of inflationary pressures.

A major driver from the supply side has been food inflation, which has both structural and cyclical components. The structural component arises from rising incomes, especially in rural areas, which is leading to a shift in dietary habits from cereals to protein foods. Inflation of protein food prices remained in double digits for much of the last three years barring a few months. The cyclical component of food inflation arises from the monsoon related spike in prices of food items such as vegetables.

The second major factor driving the current episode of inflation has been global commodity prices, especially the price of crude oil. India imports 80% of its oil demand. The global price of oil is therefore an important variable in determining the inflation outlook. The depreciation of the rupee, starting October 2011, has compounded the inflationary impact of oil prices. If the domestic petroleum sector was a free market and if global prices passed through to domestic prices, demand would arguably have declined in response to rising prices. But such a demand adjustment was blocked by the administered (subsidised) pricing regime of petroleum products.

The third major factor fuelling inflation has been wage pressures. Nominal rural wages increased at double digit rates over the last five years. Indeed, they increased so rapidly that,despite high retail inflation, real wage growth surged close to double digits in the last three years. The Government?s social safety-net programmes contributed to, and sustained, the wage-price spiral. In an economy with a per capita income of about $1,500, any increase in income quickly translates into increase in consumption demand and that is exactly what was witnessed in India. Producers were able, until very recently, to pass on the higher input prices in the form of higher output prices without sacrificing their margins.

* Growth-Inflation dynamics

India?s growth-inflation dynamics pre-crisis and post-crisis present a study in contrast. In the three year period before the crisis, the economy expanded by 9.5% on average, aided by growth in fixed investment above 15% per year. This expanded production capacity to match growing demand and kept core inflation in check. Post-crisis, the story reversed. Investment declined to half its pre-crisis rate whereas consumption demand remained at the pre-crisis level until last year, owing partly to the government?s entitlement and welfare programmes, opening up a positive output gap during 2009-11 and stoking core inflation.

* Why are India?s growth-inflation dynamics contrarian?

Over the last two years, many of our peer EMEs have also experienced a growth deceleration, but in line with standard theory, several of them have also seen a moderation in their inflation rates. In India, however, inflation has not come down in line with growth deceleration. Several idiosyncratic factors are put forward to explain this uniqueness of our macroeconomic situation: supply bottlenecks, particularly in infrastructure, sectoral imbalances, rise in wages without a corresponding increase in productivity, higher fiscal deficit and larger depreciation of the exchange rate than in the case of our peers.

To control inflation, RBI reversed the crisis period?s accommodative monetary stance in quick order. We raised the policy interest rate (repo rate) 13 times, cumulatively by 375 basis points (bps)?from 4.75% to 8.5%. Also we raised the cash reserve ratio (CRR) by 100 bps from 5% to 6%. Monetary policy is known to work with lags, and as a consequence of the tight monetary policy, WPI inflation which peaked at 10.9% in April 2010, has come down to 6.6% in January 2013. In response to deceleration in growth and decline in inflation, RBI eased the monetary policy stance starting January 2012 cutting both the repo rate (by 75 bps) and the CRR (by 200 bps).

Mitigating the vulnerability of the external sector

Over the last two years, India?s balance of payments (BoP) has come under growing pressure as evidenced most clearly by a large and increasing current account deficit (CAD). The CAD last year (2011-12) was 4.2% of GDP, historically the highest; the CAD during the current year is expected to be even higher.

The increase in CAD is quite evidently a consequence of imports growing faster than exports. The increase in imports is largely accounted for by oil and gold imports. To understand the pressure these two items have put on the BoP, it is instructive to note the following. Net of oil and gold imports, CAD last year would have been in surplus of 3.8% of GDP in contrast to a deficit of 4.2% of GDP. The surge in gold imports is explained largely by the erosion in real returns on other assets owing to inflation. The reason oil imports have been price inelastic is due to the fact that nearly 60% of petroleum products pass through an administered price regime; oil demand to that extent does not adjust to price increases. On the other hand, exports were not helped even though the real exchange rate depreciated, reflecting the fact that in a subdued global economy, exports are more sensitive to income (i.e. global demand) than to price.

* Quantum of CAD

RBI?s estimates show that the sustainable CAD for India is 2.5% of GDP. A CAD above the sustainable level, year after year, is a clear macroeconomic risk as it raises concerns about our ability to meet our external payment obligations and erodes the confidence of potential lenders and investors.

An additional concern is that we are having a large CAD even in the face of slowing growth. This is perplexing because economic logic suggests that the CAD should improve in a slowing economy due to a decline in import demand. Cross country evidence in fact supports this hypothesis. Such an adjustment has not manifested in India though because: (i) oil and gold imports are relatively inelastic to income changes; (ii) on non-oil imports, domestic supply is still unable to compete with imports, and (iii) supply constraints and subdued external demand are impeding exports.

* Monetary easing in the context of a large current account deficit

While the external sector vulnerability is a cause for concern on a number of counts, it also poses a special challenge for calibrating the monetary policy stance. In our quarterly policy review at the end of January this year, RBI cut the benchmark repo rate by 25 bps in response to the growth-inflation dynamics that I outlined earlier. Several analysts and commentators have questioned the wisdom and logic of monetary easing at a time when the CAD is rising. There are two elements to this argument: (i) an interest rate cut raises aggregate demand and hence demand for imports, and will aggravate an already elevated CAD; and (ii) an interest rate cut will narrow the interest differential between India and the advanced economies which are the source of capital, and could potentially lead to capital exit.

Let me respond to both these strands of criticism: The risk of the CAD widening further because of the stimulus offered by the rate cut is much less than apprehended for a host of reasons. First, when growth is sluggish as is the case now, the rate cut is unlikely to translate into import demand. Second, the rate cut was a response to softening inflation. Lower inflation will improve the competitiveness of our exports. Third, the rate cut was effected during a phase of easing commodity prices?particularly of oil?which will reduce the pressure on the CAD. Finally, empirical evidence shows that in emerging economies such as India, import demand is less a function of lower interest rate than of increased income. In other words, the marginal propensity to import by borrowing money is small.

On the other criticism about the impact of capital flows required to finance the CAD, it must be noted that interest rate differential is only one of the several push and pull factors that influence capital flows. Moreover, debt and equity flows have traditionally responded differently to a rate cut. While debt flows may be more sensitive to a narrowing of the interest rate differential, equity flows may actually increase because they see in this a signal of lower inflation and better investment environment. This has been the experience of India leading some analysis to all this, the ?Indian exceptionalism?.

Extracted from the fifth IG Patel Memorial Lecture delivered at the London School of Economics on March 13, 2013