Column: Indias negative growth miracle

Written by Surjit S Bhalla | Updated: Jun 13 2013, 06:49am hrs
The economy has slowed down beyond most peoples imagination, let alone expectation. The rupee has depreciated the most among emerging market currenciesclose to 7% this year and 10% since the end of April. This has caused angst, and a healthy debate, in both the economic and policy community. Just two years ago, India was celebrating the miracle of 8.4% average growth for eight years (2003-2010), including the three years of the Great Global Recession. And then a negative miracleGDP growth collapsed to 5% (factor cost) in 2012-13, or 3.2% according to the universally preferred measure of growth at market prices. What happened, and who is responsible for this negative miracle

Obviously, this miraculous decline is man-made and the result of several factors/policies. Two prominent determinants of the negative miracle are the operation of policies by two esteemed institutionsthe monetary authority, RBI, and the governance authority, the CAG. By my calculations, each of them has contributed an equal (presumptive) loss to the Indian economyat least 1% of GDP for each of the two years, or around R1.75 lakh crore each.

How can such an assessment be made By examining the determinants of investments and growth for the last 35 years and especially the last 20 (since 1993). For some suggestive answers, take a good look at the chartI believe it contains a lot of answers to several questions of policy. The chart plots GDP growth versus the (real) SBI benchmark prime lending rate lagged one year. That is itno statistical pyrotechnics, nothing. The chart reveals as close a fit as one can imagine between two variables that according to Indian myths are not even supposed to be related to each other. How many times have you heard learned economists, including those at RBI, and even more learned market economists, opine that in a country like India, real lending rates dont really matter for investment, production and growth. Then what does

The reply comes back in double quick time. It is oil prices, projects being cleared and not cleared by the government, animal spirits, complementary infrastructure investments, etc. It is nobodys case that such things do not matter. Equally, it should be nobodys case, especially from the hallowed policy making circle at RBI and PMO, that interest rates do not matter. Especially when you consider the incontrovertible evidencesimple and convincingrelating interest rates to growth. One variable alone explaining 60% of the variation in growth for the last 20 yearsyou have a better one

The following two quotes illustrate the outdated thinking among our leading monetary policy makers. Dr C Rangarajan, ex-Governor of RBI and the major adviser to the PM, had this to say about the problems, and solutions, to the negative miracle: Our investment rate has fallen but it is still growing at a rate of 30-32% We need to look at the fact that we have not been getting the full benefits of the investments that we have put in. If we activate these investments, we can get a higher growth. Subbarao (RBIs latest report on the economy) states: Growth continued to slow down in 2012-13, but could witness a slow-paced recovery later this year contingent on improved governance and concerted action to resolve structural bottlenecks especially in the infrastructure sector.

Neither individual and/or institution believes that interest rates matter for investments and growththough both believe that such rates matter for reducing inflation. If you are confused by the contradictions, so am I. But going back to the evidence. What the chart documents is that the response of growth to real interest rates is large: about minus 0.8 to minus 1 no matter what the time-period over which the estimate is obtained over the last 35 years. And interest rates equally affect investment. The strong results are that each 1 percentage point rise in real interest rates decreases the share of investment by 2.5 to 3 percentage points, and decreases growth by 0.8 to 1 percentage points. The effect is robust, and these are not small magnitudes, and they explain between 50% and 70% of the variation in investments and growth.

What is the cost to the economy of mismanagement of monetary policy The chart, and associated variables, contain clues. Just knowledge of SBI lending rates of a year earlier allows one to forecast with great accuracy the growth performance of the Indian economy. The graph has 3 linespredicted growth (on the basis of real interest rates) and a plus/minus 2% band. This tight error band contains all the predictionsa tribute to the predictive power of monetary policy via interest rates. For 2011-12 and 2012-13, growth was below that forecast by interest rates by 3% and 2.8%, respectively. In other words, something else happened, in addition to bad monetary policy, which helped collapse the Indian economy. That something else was the CAG and its weak and misguided analysis which contributed, largely, to policy paralysis.

Policies have costs and benefits. If growth is being affected by inappropriate policy, then that is of concern to all of us, and particularly to the ruling political party. Growth declines help the political opposition, just as enhanced growth helps the incumbent. Shockingly, the present RBI policy on interest rates is an eerie replay of what happened in India in the mid 1990s. At that time, India had just grown above 7% for the three years 1994-95 through 1996-97. The economic reforms of 1991 had opened up the Indian economy, decreased many structural bottlenecks, but the then finance minister, Dr Manmohan Singh, and the RBI Governor, Dr Rangarajan, most likely felt India was over-heating, misread the macro-economy, and tightened monetary policy and plunged India to slow growth for most of the subsequent decade. A very tight monetary policy most likely contributed to Congresss unexpected defeat in 1996and gave economic reforms a bad political name!

Today, the players are the same, albeit joined by RBI governor Subbarao who, not unlike Dr Rangarajan, is very much in the old-fashioned monetarist mould. Even in the mid 1990s, money supply economics was a discarded relic in most parts of the world; it is even more irrelevant today. So if history repeats itself and the Congress loses the 2014 election, at least part of the blame will be on the near-identical to 1996 monetary policy mistakes of 2011 onwards. (Again, several factors determine election wins and losses; the economy is just one, albeit important, factor.)

PS: While I believe aggressive monetary easing is absolutely necessary to get India on a positive growth path, I also believe that RBI should raise rates, yes raise repo rates, if the UPA acts irresponsibly and brings in the populist, budget busting, Food Security Bill.

Surjit S Bhalla is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Blufin, a leading financial information firm. Follow on Twitter @surjitbhalla