Column: It's the interest rate, stupid

Written by Surjit S Bhalla | Updated: Aug 31 2013, 14:20pm hrs
The GDP data for the second quarter of this year has just been released and it paints a crisis picture for the economy. The year-on-year (yoy) GDP growth rate came in at 4.4%, making it the third successive quarter when GDP growth has come in below 5%. The previous two quarters yoy GDP growth registered 4.8% and 4.7%, respectively. If this fiscal year (2013-14) GDP growth comes in below 4.8%, it will mark the third slowest GDP growth since 1991, with the slowest growth observed in both 1997 and 2000, at 4%.

In his address to the nation yesterday, the PM talked of a 5.5% growth for the fiscal year. Given that we have the yoy data for the first quarter (Zyfin Research recently published near perfect forecasts of GDP and deflator growth, both sequential and yoy), sequential quarterly growth in this quarter is around 4.2%, SAAR. Thus, sequential growth rate for each of the next three fiscal quarters will have to be close to 6% to meet the PMs forecast. There are some other scary implications. The finance minister earned the trust and confidence of many when he kept to his fiscal deficit promise of 5.2% of GDP for FY2012-13. For 2013-14, the target was ambitiously lowered to 4.8% of GDP. Contained in these estimates is tax revenue growth of close to 19%, expenditure growth of 16.3%, and nominal GDP growth of 12.8%. It is near impossible that the finance minister will even come close to the 4.8% deficit target. Nominal GDP growth expanded by 10.2%. Simple maths suggests that in order to meet the FMs nominal GDP growth target of 13%, the Indian economy will have to expand at a 14% nominal annualised rate in each of the next three quarters. This is simply not possible.

This low growth rate cannot be ascribed to external factors, US FED tapering etc. Most of our GDP decline is home-grown, and it is encouraging to note that several policymakers have admitted in recent days that it is not the outsiders, stupid. Both the FM and Subbarao are absolutely right (unlike the UPA apologists who believe that what is the problem all countries are more or less equally affected) or misguided experts who believe that 10% (food)-CPI inflation and 4% GDP growth is a sign of an overheated economy.

Potentially, there are two sources of grief for an economyfiscal and monetary policy. Regarding fiscal policy, several or most observers (including the outgoing RBI governor, Dr Subbarao) agree that UPA-2 regime has been responsible for possibly the worst fiscal policy that India has endured, and I would hazard a guess that outside of Venezuela, possibly the worst fiscal policy of any modern economy. And the nightmare just does not end. We have just witnessed the passage of two more populist Bills, Bills of a kind that would have severely embarrassed, had he been alive, the last of the great populists, Hugo Chavez of Venezuela.

What is not as well recognised, or appreciated, is that monetary policy is also responsible for the economy being in deep crisis. Given the high CPI inflation, many have defended the tight RBI policy of keeping interest rates high. Some even argue that he should have tightened much more, or that RBI should begin a new tightening mode. To bring down double-digit inflation. But is inflation in double-digits or even close The latest yoy deflator inflation is 5.8%, the lowest since 2007that is the inflation rate. By definition and construction, the GDP deflator is a more comprehensive measure of inflation. But because of its more timely nature, most analysts take the CPI as a surrogate.

And so they should. Data for over a 120 countries shows that there is a close relationship between the CPI and the GDP deflator. On average, the difference in the inflation shown by the two variables is less than 0.25%. The same holds true for India for the long time-period 1980 to 2007. For this 28-year period, average CPI inflation was 7.6% per annum, and average GDP deflator inflation 7.2%. Around 2007, this historic equivalence broke down. For the last 5 years, CPI inflation has been 9.6% per annum, and GDP deflator 6.8%, an annual difference of 2.8%. According to the just released GDP data, for 2012-13, this difference is 4.2 percentage points.

The reason for this large anomaly is food inflation. As commented by me on several occasions over the last three years, this high food inflation was literally engineered by the UPA government via massive increases in procurement prices. In the space of three short years 2006-08, the relative price of food increased by 33%. This food inflation is what is causing the divergence between GDP deflator and the CPI. The latter has a near 50% weight of food, while the former has a weight of agriculture of less than 20%.

The divergence is large, very large. The difference is so large that it changes the very nature and interpretation of monetary policy. It suggests that RBI, fully supported by the PMEAC headed by Dr Rangarajan, has been fighting inflation that was not there, or that it could not affect. Food inflation in India is political inflation, and inflation caused by administered, not market, prices. Monetary policy cannot affect the magnitude of administered prices. Food inflation might play well on TV channels and be good for their TRPs, but it is not inflation that RBI, or the ministry of finance, or now Governor designate Raghuram Rajan should be looking at.

There are two very strong implications of this misguided misreading of inflation. First, in contrast to protestations of RBI, there is a divergence of 4 percentage points in the real rate of interest. If the lending rate is 15%, and inflation 6%, then most borrowers are paying 9% real; with the CPI, the real rate is only 5%. Is it any wonder then that the economy has stalled, and stalled at near historic low growth rates of 4.5% for the better part of the last two years.

Most investors do not have the time, inclination, or expertise to even begin to question the words of a central banker. They take it as a given that RBI must know what it is talking about and if RBI Governor says that inflation has been 10%-plus for the last few years, so it must be. They plunk this 10% average into their excel sheets, along with considerably more reliable CPI for other countries, and lo and behold they get a crude value of R70/$ as the new fair value of the rupee. But if inflation has been cumulatively some 17% lower, then the experts will get a lower fair crude value of the rupee at 60 (70 divided by 1.17).

What is to be done now There are countries like Brazil and Indonesia who are hiking rates, not because of tapering but because their correctly measured inflation rates have accelerated beyond their targets. India has the opposite problem. Regardless of whether you are an inflation target policy believer or not, you should be recommending to India that they should be cutting short-term rates, not raising them. Incidentally, Zyfin Research monthly GDP calculations suggest that sequential GDP inflation is down to a 1.7% annualised rate.

Indias growth recovery can only begin once the policymakers (and their advisers) recognise they have made some grotesque errors of data interpretation and monetary policy. The time to cut rates was well before yesterday.

Surjit S Bhalla is chairman of Oxus Investments, an emerging market advisory firm, and a senior advisor to Zyfin, a leading financial information company. He can be followed on Twitter, @surjitbhalla