For months, India’s policymakers had been talking of an economic recovery on the track. Many analysts also considered likewise. Growth would be driven by a push to capital investments by the government and private consumption boosted by sharp fuel price reductions and lower inflation, it was said; just wait a bit. An even longer held belief was about private investments reviving as bottlenecks were relieved and stalled, infrastructure projects were cleared at a faster pace. Somewhere along the way, came a new GDP series that straightaway transformed yesterday’s 5%-growth zone into today’s 7%. That further kept up the facade, although it made it hard to argue why steep interest rate cuts were needed if growth was as robust as 7%-plus and accelerating further too.
It is quite another matter that most indicators never adequately supported the gradual recovery story. Neither did they match the new national accounts (they still don’t!). If the economy was indeed on an upward trajectory, why was this not showing on the financing side, for example? Why was then capacity utilisation falling each quarter, successively lower on average every year? What about the contractionary effects of a three-year long fiscal consolidation? And why at all, if demand was picking up, were non-performing assets (NPAs) rising relentlessly?
All this and more stood uncovered by RBI’s surprise of September 29, when it lowered the benchmark policy rate by a hefty 50 basis points. While the central bank visibly admitted to intense economic weaknesses in its statement, the incoherence of this monetary action is even more telling about its anxiety about growth.
Consider growth first: if recovery was a ‘work-in-progress’ in RBI’s August 4 assessment, it is ‘far from robust’ end-September. Rural demand remains subdued, says the central bank, as reflected in the still shrinking tractor and two-wheeler sales. External demand conditions have weakened, pulling down exports and combining with weak domestic demand to lower capacity utilisations and new orders, while increasing finished goods’ inventories-to-sales ratios. Its latest assessment of aggregate demand states this is now weak enough to offset the raised producer margins from lower input costs and hold back fresh intents of investment. On the services side, construction is weakened as reflected in the low cement demand and large inventories of unsold homes.
It is not as though RBI did not list some of these developments in past reports. What is striking is that for the first time, the central bank pulled all of them together to justify a sharper cut. These trends in the real variables are not new, but RBI either ignored or did not admit to these evidences before. For example, RBI’s own Quarterly Order Books, Inventories and Capacity Utilisation (OBICUS) surveys have successively revealed steadily declining in average utilisation rates in manufacturing. Its in-house balance-sheet analysis of non-financial private corporate businesses have uncovered a persistent deceleration in firms’ sales and profits: While its latest, September 1, release tells us that aggregate sales’ growth dropped to 1.7% in FY15 (4.7% in FY14) and net profits contracted -0.7% (-5.1% last year), its previous (July 1) release had underlined that both variables contracted in the last quarter of FY15, following their stagnation in the previous (Oct-Dec 2014) quarter!
Then, the central bank countered indications from the puny bank credit growth by noting the increase in non-bank resources like commercial paper and corporate bonds, never a sufficient or matching offset in the aggregate sense. But the most betraying evidence against a recovering-economy story was the unabated rise of non-performing assets. Again, the most granular information on this is with RBI. Apart from its own data, the piling inventories of unsold residential properties and abysmal transaction volumes are nothing new; neither is cement demand, equally reflected in capacity utilisation rates. And a structural downturn in rural demand from multiple sources has been around for more than a year now.
All those were ignored as RBI remained focussed on taming inflation and anchoring inflationary expectations of the public so as to create the ground for solid, long-term growth. So, what led the central bank to change course? Did it expect inflation to undershoot its August projection of 6% by January 2016? For it now forecasts inflation to be only marginally lower by a mere 20bps, to 5.8%. That hardly yields space for a 25 bps reduction in the policy rate, leave alone a 50 bps one!
One can argue RBI felt more confident in meeting its one-year-ahead target of 5% inflation by January 2017 as it now expects oil and commodity prices to remain subdued for a much longer period compared to its August baseline, due to China’s faltering and further weakening of world output. Therefore, it front-loaded its policy action.
But what about domestic factors? Why did RBI ignore its latest household expectations survey for three-month and one-year range, where expected inflation rates are in double-digits and directionally heading up? Strange too that the seasoned central bank accepted the agriculture ministry’s first crop estimates of kharif food production, based upon more area sown, in a monsoon where rainfall dried up in August-September and which could severely depress yields.
Therefore, the moot question is: If food inflation does pick up post-harvest in October-November, in an environment of elevated inflation expectations, how would the central bank respond? As the RBI Governor repeatedly reminded us as he implemented the new monetary policy framework: there was no point in hastening a policy rate cut if it were to be reversed no sooner!
Why has RBI taken this excessive risk? Or is there in this risk-taking an implicit recognition that domestic demand conditions are far weaker than what headline GDP numbers suggest, i.e., the negative output gap much larger than previously assumed? For sure, the 20 bps scaling down of its GDP growth forecast for FY16 to 7.4% does not quite correspond to this perception. But we will have to wait and see if the central bank gradually tapers off its growth projections ahead quarter by quarter!
Although the RBI’s Monetary Policy report dismisses the persistent decline in wholesale price inflation (WPI) as not indicative of deflation, arguing that a calibrated, orderly disinflation process is underway, is the central bank silently worried that some key sectors are in severe distress? With a constant gust of fresh NPAs, the most forceful evidence yet against the recovery hypothesis, the RBI appeared convinced it was time to sharply change course. But whether a 50 basis points reduction has come too late in the day in an environment of inadequate transmission is something only time will tell!
The author is a New Delhi-based macroeconomist