The realisation that economy could be demand-constrained came a bit too late.
As 2015 fades away, it will be remembered for the historic agreement between the finance ministry and RBI, formalising the inflation-targeting framework already in operation. Said by many analysts to be the most important structural reform of the year, it signalled the government’s willingness to allow RBI the freedom to run a rule-based monetary policy and keep fiscal discipline for the operational success of the framework. Thus, stabilising inflation became the top macro objective, ahead of growth. And both monetary-fiscal policies remained geared to compressing demand and tame CPI inflation, the new monetary policy anchor.
And yet, most analysts projected growth accelerating to 7.5%-plus in FY16; the government’s own forecast was more optimistic at 8-8.5%. There was a near-consensus that the contractionary macro policy stance could be coterminous with a positive output effect or a favourable sacrifice ratio! With large terms of trade gains, estimated between 1-1.5 percentage points, the government aimed to boost growth through higher public capex for large multiplier effects, lower inflation to increase consumption demand and monetary easing as well as supply-side reforms to revive private investment.
Two quarters down the line though, doubts have emerged. The mid-year review (MYR) sharply downgraded growth projections to 7-7.5%, nearly 100 basis points. More strikingly, it hinted growth may not accelerate in FY17 too, surprising many who still projected an uptick. Realising the one-time, terms-of-trade gains may gradually taper off, the report suggested a review of the medium-term fiscal framework, and made a case for further monetary easing to spur demand.
Unsurprisingly, this invited a barrage of criticism and potential threat of “loss of credibility” with reminders of the agreement signed just 10 months ago. The MYR should have appreciated that under the new framework, the policy rate is mostly rule-based with limited operational flexibility, regardless of who sets it—whether the present RBI Governor or the proposed monetary policy committee, in the future. Similarly, any dilution of the fiscal consolidation path would revive fears of the return of fiscal dominance, undermining the framework’s success. Surely it is a bit too late to turn back, even if temporarily?
But those of us who remained unconvinced about the timing and contour of the agreement can only empathise with the MYR’s predicament in underscoring the economy might be severely demand-constrained. Quite correctly, in our view, it has highlighted uncertainties that could generate weakness ahead, but at best it can regret in hindsight for not having flagged these when the agreement was being discussed.
One such uncertainty flagged by the MYR is the steep deceleration in nominal GDP growth—to 7.4% in the first half of FY16 from a corresponding 13.5% in FY15. While the report expects 8.2% nominal GDP growth for the whole year, this will not be significantly different from the current benchmark yield at 7.75%. The concern therefore is if such low nominal GDP growth levels persist in FY17 and extend beyond, not only will the government’s debt dynamics worsen, the deterioration will be more so for the private sector, especially those already grappling an excessive debt burden. But, to us, the bigger worry should be the revival of private investment that the MYR fails to mark: With base rates above 9.0% and effective lending rates in the 12-14% region, the return on assets could slip below the cost of funds—a classic, text-book situation in which even healthy firms might be better off putting all their resources into bank deposits!
The second uncertainty relates to assessment of the output gap. RBI noted in its latest bi-monthly monetary policy review that a small gap remains but is closing rather slowly. By contrast, the MYR remains ambivalent, suggesting indications are in either direction, particularly if there is evidence of spare manufacturing capacity. But if there is a case for a bigger output gap, then what explains a reversal in inflation, particularly core-CPI, in recent months? Does it raise questions if potential output growth rate is over estimated? It is needless to add here that the new GDP series without a back series has compounded these problems.
The last but a key source of uncertainty is measurement errors, especially assessing if real aggregate demand is overestimated by the new GDP estimates. While arguing these are unbiased, the MYR acknowledges issues about price deflators used, above all, that for producer services, forming 21% of GVA. RBI, too, flagged this in its September monetary policy report. Coincidentally, these very sectors have been showing robust growth, with the MYR admitting that with as much as an 8.5 percentage point wedge in producer-consumer prices, the overestimation could be non-negligible.
But if one were to presume the overestimation if any, is negligible, it follows the underlying demand conditions must have been quite robust; any temporary slowdown in that case needn’t warrant a review of the macroeconomic stance. Considering RBI has already eased 125 basis points with full transmission still underway, critics would be right in suggesting the focus ought to be continued supply-side reforms. But the MYR appears uncertain and worried: if such enormous, positive terms of trade benefits failed to accelerate growth, what might be the case when this wears off?
There is a marked difference between India and China here: While the Chinese authorities may have consistently overestimated growth rates for public consumption as is commonly held, they always had a fair grasp of the underlying real conditions for themselves; hence, they have been able to respond with appropriate and timely policy actions. For India, overestimations of GDP, if any, were non-intentional, as the MYR rightly states, and could be due to data inadequacies. But the unintended fallout could be an inability to judge the real economy, which could result in potential policy errors. In this light, by suggesting a relook at the current macro policy stance, the MYR is quite right in trying to balance risks from any possible overestimation.
The MYR identifies the key culprit rightly, viz. the large divergence in CPI-WPI inflation rates. Many believe the current WPI trend is mostly import-driven and should gradually normalise. But will that substantially reduce the divergence? Emphatically no, because WPI inflation is only half the story; the other half lies in the unfolding trend in CPI inflation. Those of us who had opposed headline CPI as the policy anchor had noted the supply-constraints in food inflation, which would require considerable time and policy efforts to address. But what has surprised us is the reversal in services inflation, largely captured in CPI core, and exhibiting signs of supply-constraints. Thus, any sign of convergence between WPI and CPI seems beyond the realm of medium-term.
Finally, the worrying part here is if supply-side reforms fail to lessen structural constraints and help lower inflation, as per the medium-term glide path. A rule-based monetary policy framework then could sooner be tempted to infer the economy’s potential growth rate is much lower than currently estimated, notwithstanding the high capacity underutilisation rates and weak credit demand. The policy response then would be obvious—further tightening! Any flirtation with the fiscal stance therefore, would carry its own risks. While signing the inflation agreement, these possibilities should have been foreseen.
The author is a New Delhi-based economist