Governor Raghuram Rajan has gone public with his concerns—what could have been an in-house worry at RBI for quite some time—that private and public investments are not picking up, and as much as 30% of capacity is idle. This summary of economic conditions may have surprised many, especially against the backdrop of three distinct, positive narratives from the central bank: one, a gradual cyclical recovery since past three-four quarters due to government’s initiatives to restart stalled projects, improve governance and policy reforms; two, a further push from a sharp decline in CPI inflation with resultant increase in purchasing power and consumer demand; and three, lower input prices for manufacturers mean higher corporate margins—sure signs the economy is on the right path. If one were to add three other claims from the government: one, stepped-up public infrastructure investments; two, escalated FDI inflows; and three, a sharp increase in indirect taxes, as further evidence of economic activity, one is left wondering why investments are held back!
Instead of exploring answers currently on offer, viz. focus upon sorting out banks’ NPAs and usher in more structural reforms through administrative as well as legislative channels, we attempt a counter-narrative of readjusting macroeconomic policies to the resurgence of deflationary conditions across countries. Our conviction arises from the recent rout in commodities’ markets. This suggests the world economy is in fundamentally different terrain of low demand and oversupply. Global growth is too weak to pressure prices, commodity prices are continuing to fall, wages growing too slowly and spare capacity rising in many emerging market economies (EMEs). These are hardly favourable conditions for investments to revive in any part of the world, including India.
In October, the IMF projected global prices (in dollars) of non-fuel commodities including food to decline 5% in 2016 after a 17% fall this year. Prices of manufactures were expected to follow suit—fall 0.7% in 2016, following a decline of 4.1% in 2015. Oil prices, too, were forecast to decline 2.7% next year on top of their 46.4% plunge in 2015. A further slump in commodities signals the intensification of those deflationary forces, while the continued absence of upward pressures upon food and manufactures’ prices indicates its broad spread.
The alarm bell rung by commodities in the existing, weak global environment draws an inevitable comparison with the Great Depression of 1929. This was characterised by a large, prolonged deflation, which too was commodity-induced. The first signs originated from the commodity-producer countries (nowadays EMEs); a surfeit of production capacity and competitive devaluations helped export deflation; and like today, the US was growing but the rest of the world was fighting to grow. A material difference between then and now is that the Chinese economy wasn’t as big or well-integrated.
Time will tell how far and deep are the similarities. Opinion whether the resurgence of deflationary strains in the world is temporary or extended is divided. Nonetheless, the extended deflation impetus, starting with the oil price collapse in mid-2014 and centred upon commodities in 2015, has serious consequences when demand is already subdued. The effects are visibly manifest in the negative producer price indices in many EMEs, including here in India.
As a net importer of oil and commodities, India is widely seen as benefiting from deflation, for it provides positive income effects that eventually increase spending. Can we, however, be sanguine about these positive gains? Are there offsetting, negative effects too serious to ignore?
The 1929 experience was that positive income effects were not really observed; checkmates included trade restrictions and currency depreciations that further magnified the problem. It makes one uneasy that consumer spending has not gained meaningful strength in India, although fuel consumption has risen. Domestic demand has also reoriented towards cheaper imports, as manifest in increased imports of steel, electronic goods and many other items. Spending is also perhaps countered to an extent by higher import duties to support domestic producers and, hence, relatively higher domestic prices. Over a longer period, the creation of fresh or additional import demand cannot be ruled out, just as it isn’t hard to contemplate further substitution of domestic production by more competitive suppliers overseas if the global environment of overproduction and weak currencies persists or deepens.
Far more are anxieties on the production side, however. This is marked by high debt levels, a significant idleness of resources and lack of pricing power, low demand as obvious from the unimpressive growth of industrial output and prolonged fall of exports, decelerating bank credit growth, and an absence of enthusiasm for investment. Deflationary pressures in producer prices push down growth of nominal revenues, which increases the relative costs of debt-servicing and magnifies over-indebtedness. Such signs are visible: loans continue to sour, despite restructuring and other solutions; and debt levels of many large firms have risen even after asset sales and other pruning measures, and are predicted to increase more ahead. The debt overhang is also restricting fresh investments, which equally faces headwinds from industrial overcapacity worldwide and much idleness within. Investment is retrenching in sectors where demand has permanently slumped (for example, metals). In a persistent milieu of weak output and prices, there’s bound to be a further retreat as previous misallocations are corrected. A reallocation of resources can be quite costly, never painless and takes time even in normal conditions; when demand and prices are both falling, it is even more so.
In balance, it is hard to be very complacent about income gains from oil- and commodity-driven deflation. When considering the complete environment, these could be quite limited or dissipate quickly. And they might be grossly insufficient to propel the economic cycle. Fixed investment, which delivers the biggest punch in an upswing, is conclusively missing, including the much-awaited impetus from public capex. Then, note that the imported deflation from last year interplays with policy-induced negative demand shocks that go back to 2012—intentional disinflation from tight monetary policy geared to a CPI inflation target and fiscal compression of aggregate demand. The combined effects of these are exorbitantly high real interest rates for producers that endure in the worsened balance sheets of firms and structurally weaker banks.
And now, another round of battering in commodity prices stretches negative growth of producer prices into 2016. The risks to further downside to CPI core inflation cannot be ruled out too, notwithstanding higher food prices. Real interest rates could then be still higher.
The protracted stretch of deflation shock and its adverse consequences then demand more supportive and benign macroeconomic policies: these need to reflate than further deflate as they currently are. In other words, stimulus from both monetary and fiscal sides is the need of the hour. Sidestepping the bouncy official growth numbers, this is the time to acknowledge that without macroeconomic policy support, a cyclical rebound might not be achievable. Constraints of policy space are quite overdone, especially in relation to the overall macro environment—the stock of public debt, at about 67% of GDP, is hardly alarming. Likewise, tying the economy to a headline CPI inflation target is pointless when the gap in producer-consumer prices is exceeding 6 percentage points, pushing real interest rates higher than they were last year. Public spending on infrastructure should be increased significantly above current levels to offset the contraction in private business investments. Monetary policy must ease far more to combat the deflation challenge. The policy focus upon structural reforms is apt, but growth effects will be felt only in a few years. Meanwhile, the economic cycle could well submerge in a deflationary swamp.
The author is a New Delhi-based macroeconomist