Rajan would do well to pay heed to Arvind Subramanian
With the economy growing at 7% in Q1FY16, and chief economic advisor Arvind Subramanian saying it was an under-estimate—he is still sticking to his 8% forecast for the year—it is difficult to reconcile this with deflation, a fear Subramanian expressed at his interaction with the media on Wednesday. Traditionally, as in the case of Japan, deflation is seen as linked to demand stagnation, with consumers deferring purchases in the knowledge they will be cheaper in time to come. With consumer demand growing at 7.4% in Q1, India looks far from this Japan-style situation. To that extent, it appears Subramanian may have exaggerated his case a fair bit—India is certainly facing disinflation, not deflation.
But look at the growth more closely, and it becomes clear that Subramanian is making a deeper point. With WPI inflation in negative territory for 8 months now—and manufacturing inflation for 4 months now—India’s real interest rates have climbed to the 12-13% range. At such rates, it is difficult to see who is going to invest in creating fresh capacity—more so when capacity utilisation in the manufacturing sector is a mere 75% as compared to 82% in 2011. So, while India’s population growth will generate a certain basic demand, and lower global commodity prices help raise GDP by boosting value addition, the big kick to GDP growth will come only from the investment cycle picking up. Also, while the change in methodology in January ensured a sudden jump in GDP, this impact will soon wear out and GDP growth will revert back to normal unless genuine economic activity picks up. During India’s boom years, the big boost came from a jump in capital expenditure —this rose to 38.1% of GDP in FY08, fell and then rose again to 38.2% in FY12, but is likely to be around 31.4% right now. With real interest rates high and no sharp boost in global demand this time around, investment is likely to remain low. So, over the medium-term, it is likely that even consumption growth will remain muted. To a certain extent this is already happening. FE’s lead story on Wednesday was about 7.5 lakh unsold flats in 7 cities—buyers are waiting for prices to fall further—worth around R4 lakh crore, and estimates are it could take up to 5 years to clear the inventory. In the case of the automobile sector, while there is talk of a slight revival, keep in mind sales of passenger car sales of 2.6 million in FY15 were lower than the 2.7 million in FY13; at 6.1 million, commercial vehicle sales were lower than the 7.9 million in FY13; two-wheeler sales at 16 million were, though, higher than the 13.8 million in FY13.
So, in order not to slip into deflation—the chief economic advisor said that in terms of prices, India was closer to deflation territory and far away from inflation territory—RBI needs to cut repo rates sharply so as to stimulate both consumption and investment demand. It would, however, be naïve to expect the central bank to do all the heavy lifting. The government needs to do its bit by clearing big reforms—while greater expenditure on road building is welcome, lack of policy reforms in the petroleum and telecom sector, for instance, has hit investment badly. It is only when RBI and the government act in tandem that any serious boost to investment can be expected.